Fitch says stable outlook for Sri Lanka’s insurance sector

Fitch Ratings Lanka in a new report has said that its Outlook for Sri Lanka’s insurance sector is Stable. Fitch considers the credit fundamentals of agency-rated issuers to be underpinned by their healthy capitalisation and good profitability, supported by improved macroeconomic factors.

Key challenges to local insurers remain that of maintaining underwriting profitability in the motor segment (given competitive pressures), and also in maintaining market shares in life and non-life insurance as new players enter the market.

Sri Lanka’s insurance sector recorded a 20% yoy growth in 2010, following a contraction in the previous year, from a slowdown in non-life insurance. Fitch views the premium growth of 11% in H111 to be sustainable in 2012 given growth potential in the life segment, which is still relatively underpenetrated.

Also, there are improved prospects in the non-life segment, following a sharp increase in new vehicle registrations and higher trade activity, supported by better domestic growth prospects.

Revised regulations by the Insurance Board of Sri Lanka require insurance companies to separate their life and general businesses by 2015, and increase the minimum capital requirements (MCR) for each business line.

Fitch notes that although the revised MCR of Rs. 500 m (from Rs. 100 m) only applies to new licenses, this is likely to be extended to existing players in the near-to-medium term. This could lead to some consolidation as many of the smaller players currently fall short of the requirement.

Fitch believes industry capitalisation should strengthen in the medium-term with higher MCR and mandatory listing requirements (deadline is 2016) providing companies with an added avenue to raise funds.

However, for insurers who already meet the MCR, the separation of life and general segments and consequent re-allocation of capital may change the risk profiles of certain companies post separation.

Price competition remains high in the motor segment, and newer players have been eating into the market share of larger and more established companies. The claims ratios for the motor segment averaged 64.2% over 2007-2010, and are likely to remain high in 2011.

As such, underwriting profitability remains under pressure with many companies posting combined ratios above 100%, and having to rely on investment income to compensate for underwriting losses. Fitch notes that the high investment returns earned in 2010 are unlikely to recur in 2011 and 2012. Investment income fell to 10.8% of average assets in H111 (2010: 18.8%).

Fitch notes that intensified competition in the motor segment, which could further weaken underwriting profitability (owing to higher claims ratios), could affect the outlook on the sector, as could a sharp decrease or a sustained weakening in capitalisation or solvency ratios. Healthier competition with reduced pricing pressures and lower market share concerns could be positive for ratings.

Here is the full report

Rating Outlook

Stable Outlook for 2012: Fitch Ratings’ outlook for Sri Lanka’s life and non-life insurance sectors is stable, indicating that most ratings are likely to be affirmed in the next 12-24 months. This reflects the sound operational and financial performance of the insurers rated by Fitch, as well as their healthy capital position, while taking into account the challenges in maintaining market share and underwriting profitability in the non-life segment.

Tighter Regulations: The Insurance Board of Sri Lanka (IBSL) tightened the regulatory framework for insurance companies during 2011. Minimum capital requirements (MCR) were raised, with companies also required to separate their life and general businesses by 2015 – and be publicly listed by 2016. Together with an improvement in disclosure and transparency, this would also make it somewhat easier to raise capital in future.

Improving Capitalisation: Industry capitalisation should strengthen in the medium term; with capital requirements set to increase for existing companies, and mandatory listing requirements. While the higher MCR only applies to new licences, this is likely to be extended to existing firms – and may result in some consolidation in the medium-term, with smaller companies falling short of the requirement.

Intense Competition in Motor: As in most countries, price competition remains high in the motor segment, and new entrants have been eating into the market share of the larger, more established companies. As such, underwriting profitability remains under pressure, with many companies posting combined ratios1 of over 100%.

Lower Investment Yields: Investment income for the peer group2 fell to 10.8% of average assets in H111 (2010: 18.8%). Higher investment returns in 2010 were supported by a surge in share prices and a steep fall in interest rates, which contributed to capital gains on share and bond trading portfolios. Gains of this magnitude are unlikely to recur in 2012, although the potential remains for investment returns higher than the historical average, in light of the positive growth prospects for the country.

Premium Growth Sustainable: Premiums rose by 11% in H111 over the corresponding period the previous year. Aside from a contraction in non-life premiums in 2009, the sector has developed steadily over the preceding six-year period. In Fitch’s view, this growth is likely to be sustained due to the potential in the life segment. Life is still relatively under-penetrated, and prospects will brighten for the non-life segment with a sharp increase in new vehicle registrations – as well as overall economic prospects for the country.

What Could Change

the Outlook

Weaker Capitalisation or Solvency: A sharp decrease or sustained weakening in capitalisation or solvency ratios could lead to the outlook being revised to negative.

Motor Profitability: Intensified competition in the motor segment which could further weaken underwriting profitability – owing to higher claims ratios – could be negative for ratings. Healthier competition with reduced pricing pressures and fewer concerns over market share, could be ratings positive.

Key Issues

Improved Growth

Prospects Post-War

Fitch believes that higher premium growth in 2010 and H211 is sustainable over the medium term given improving lapse ratios and growth potential in the life segment, as well as higher vehicle demand and trade activity supporting non-life growth prospects. Fitch’s forecast for GDP growth in 2012 is 7.5%-8.0% for 2012.

Steady Growth

The Sri Lankan insurance market has seen steady (albeit slow) growth over the 2006-June 2011 period, with the exception of a contraction in 2009. Non-life premiums shrunk by 3.1% in 2009 owing to a weak macro economy, a slowdown in vehicle demand and weakening of import/export segments.. However, with improved growth prospects since the end of the Sri Lanka civil war in mid-2009, lower interest rates and higher disposable income supported growth in both segments in 2010 and 2011. Fitch’s peer group posted an 11% year-on-year (yoy) premium growth in H111; 55% of premium income is generated from the life segment.

Low Insurance Density

and Penetration

Insurance penetration in Sri Lanka is low in relation to other Asian countries. Total premiums/GDP is 1.2% versus a regional average of 6.2%3. Fitch believes one of the key reasons for this is Sri Lanka’s relatively low per capita income. The number of life policies/population was 10.9% at end-2010, and is rising. In Sri Lanka, insurance is viewed more as a risk management tool rather than as an investment vehicle, and the availability of a pension scheme for state employees has resulted in a lower appetite for insurance (investment policies) from this segment. However, investment-linked policies are gaining popularity, and the second-largest insurer in the market for life generated over 50% of its life premiums in 2010 from unit-linked products.

While the main distribution network for life insurance has been that of tied agents, bancassurance is a growing channel – and many companies are linking up with banks to cross-sell products.

Evolving Regulatory Framework

The Insurance Act was amended in 2011 (Regulation of Insurance Industry (Amendment) Act, No.3 of 2011), with revisions introduced in relation to capitalisation requirements, and separation of life and general insurance businesses.

Business Separation and Higher Capital Requirements – Could Lead to Consolidation in the Medium Term

The MCR was increased to LKR500m (previously LKR100m) for each insurance business line. While this only applies to new companies, the regulation is likely to be extended to existing insurers in the short term. With many of the smaller companies falling short of this requirement, there could be some consolidation within the sector in the short to medium term. Every insurer will have to be publicly listed by February 2016 (2014 for new insurers). Furthermore, as per revised regulations, composite insurers will be required to separate long-term or general segments by 2015. In light of these listing requirements, most companies will split their businesses prior to the listing – with most likely to take place in 2012-2013. The re-allocation of capital by these companies could change their existing risk profiles.

Revisions to Permissible Investment Assets and Admissible Assets for Solvency – Adds Greater Clarity

Rules on investment composition of insurance funds and admissible assets for solvency computations were revised during 2011, with a more comprehensive list provided in both cases. Asset risk has been given greater emphasis, with credit ratings included as guidelines for investments in debt securities and bank and finance company deposits. Such revisions could support an improvement in the risk-based capital position of the sector. Although not currently in use locally, the regulator has indicated its plans to move towards a risk-based capital model in the future – though this is probably not likely in the near term.

As per regulatory requirements, a minimum of 20% of the general fund and 30% of the life fund is required to be invested in government securities. There are also maximum investment limits for equity investments, corporate debt, deposits, and other asset classes. At end-2010, over 50% of the sector’s life fund assets and 23% of general fund assets were invested in government securities.

There is limited availability of longer-term investment assets in Sri Lanka, owing to its relatively less-developed corporate debt market. As such, maturity-matching in the life funds can be challenging.

Listed equity investments are subject to a ceiling of 5% of fund assets (or 5% of the investee’s shareholding), with total investments in related companies subject to a cap of 7.5% of funds. In addition, for solvency computations only 7.5% of these related-party investments are admissible. Investments in gold which were fully admissible under the previous directions are now limited to 20%, with a higher amount included only with the permission of the board. Furthermore, the gold must be kept in the custody of a licensed commercial or specialised bank to be admissible for solvency purposes. Investment in deposits with licensed commercial or specialised banks and finance companies is only permissible if the bank carries a rating above investment-grade, as defined by the Act. This is also the case for admissibility for solvency.

Policyholder Protection Fund

In keeping with provisions of the Insurance Act, all insurance companies must pay a cess of 0.2% of the net premiums of the life fund, and 0.4% of the net premiums of the general fund, into the Policyholders Protection Fund. This fund is managed by the IBSL, and is to be used for protection of policyholders for any purpose as determined by the IBSL. The fund balance was LKR1.0bn at end-2010.

Motor Underwriting Profitability Under Pressure

Concentration to the motor segment increased further to 57% of non-life GWP in 2010 (2009: 53%), driven by a revival of the vehicle market in 2010 and 2011 owing to lower import duties. New vehicle registrations during the nine months to September 2011 were up by 54% yoy.

As in most countries, the motor segment is fiercely competitive – with competition mainly in price form. As such, underwriting profitability has come under pressure and claims ratios in this segment are the highest – averaging 64% in 2007-2010, with companies relying on investment income to compensate for underwriting losses. Investment income increased in 2009-2010, but is unlikely to be maintained at similar levels in 2011-2012. So pricing would need to improve to enable the sector to maintain non-life operating profitability at the current levels. Prices could stabilise as companies attempt to focus on a more service-oriented approach, and compete on other aspects of the product.

Sustainability of

Investment Income

Aided by a sharp drop in interest rates and an upswing in the stock market, insurance companies benefited from capital gains on their equity portfolios and from treasury bond investments from 2008-2009 when interest rates were still high. A few companies increased their equity exposure in view of improved share prices from 2010. However, the potential for continued gains on a similar magnitude is limited. With lower interest rates likely to be maintained at single-digit levels in the medium term, the sector will experience lower returns on its government bonds and bills portfolio which account for the bulk of invested assets. Insurance companies are permitted to invest up to 20% of assets in foreign-currency assets, subject to guidelines specified by the board.

Healthy Capitalisation

Most companies in the peer group are well within local solvency requirements. Solvency margins may benefit from a more comprehensive list of asset classes for admissible assets; however, the admissible proportions have been reduced in the case of listed equities, unit trusts, bank deposits, and land and buildings. The equity/assets ratio improved in 2010, but premium growth and business separation could result in some companies posting weaker capital positions.