Free Reserves rise in 2019-20, but can it continue?

In broker Gallagher’s webinar update last week on the state of the Group P&I Clubs, the contributors noted that free reserves recovered well in 2019-20, with $650-$700m in investment returns pulling back about half of the decline recorded in free reserves the previous year.

Gallagher noted that their update only had full reports from seven of the 13 clubs, with the Covid-19 pandemic leading to a later appearance than usual of the formal statements. However, Gallagher’s internal research, plus guidance from all but one of the group clubs (Japan), had enabled them to put together the numbers.

The increase in free reserves was due to back-year claims improvements, although some Clubs would say that their claims prudence was conservative to start with, i.e., over-reserving, as well as significant investment return gains.

Group Total Free Reserves

Year $m
2013-14 4,309
2014-15 4,609
2015-16 4,840
2016-17 5,328
2017-18 5,758
2018-19 5,354
2019-20 5,539

Divisional Director Alex Vullo noted that the past 20 years we had seen $6.6bn of investment return and $1.6bn of technical underwriting losses.

Roger Ingles of Elysian Insurance observed that, while most clubs’ free reserves fell back in 2018-19, 2019-20 had seen a mixed bag of returns.

The poor result in 2018-19 was due to a year on year decline in investment yields to around $100m, which, coupled with returns of capital and UK Club’s redemption of a hybrid issue, led to an overall negative result in 2018-19.

In 2019-20 investment yields bounced back to yields of $650m to $700m, so despite further deteriorating technical results, free reserves regained about half of the prior year decline.

Overall free reserves rose by $185.5m. Eleven clubs reported a free reserves increase, albeit some only marginally. Only North of England and Standard saw reversals, both caused by non-accident year issues specific to the individual clubs.

Despite provisionally waiving the final 20% of its calls, Gard still achieved a positive change in free reserves. Both Britannia and Steamship increased free reserves, even though they made capital returns.

Ingles observed that “the oddballs here are the American Club, which saw free reserves rise during the year, but only because of excess calls on two older years, and London Club, whose increase in free reserves was underpinned by a timely revaluation of their office premises.

$m 2017-18 2018-19 2019-20
ETC Basis 596.2 (219.4) 274.4
AC Basis 459.4 (270.7) 226.8
Change FR 429.4 (404.0) 185.5

Estimated Total Call (ETC) basis = total profit, had all premiums been called in full.

Advance Call (AC) basis = profit after return calls/deferred call adjustments.

Change in free reserves (FR) = Net Profit/Loss after capital distributions.

Ingles said that “if we had looked at the club results 15 years ago it’s most likely that the AC basis would have been higher than the ETC result, since excess calls were far more frequent back then and return calls were very rarely seen. There would have been no capital distributions at all.”

He continued: “The market seems to be in transition, with excess calls now being largely seen as unacceptable, and returned premiums being steadily replaced by capital distributions. You might even say dividend. It’s neither here nor there what we call them.” He said this was likely to be the future business model for the International Group. Premiums would approach being fixed in nature, with the Members being given a dividend where circumstances dictated.

Free reserves club-by-club 2019-20 ($m)

American 73.7
Britannia 594.9
Gard 1,179.9
Japan 239.2
London 173.9
North 444
Shipowners’ 340
Skuld 465.8
Standard 393
Steamship 515.3
Swedish 222.1
UK 559.8
West 338.3

Summing up, Alex Vullo said that, at $5.5bn, total free reserves were approaching the historical high of $5.7bn achieved in 2017. “It’s very safe to say that the clubs remain financially healthy, with all continuing to report that they are over-capitalized with reference to Solvency II requirements”, he said.

He observed that some clubs were using excess free reserves to invest members’ money into growth projects, recent examples of which were North of England going into hull & machinery and offshore, West of England making investments into cyber, strikes and delay products, and the UK Club venturing into the offshore market. .

“We often debate on whether diversification is good. For Gard, clearly they started early and it works well for them. Skuld have seen some ups and downs. Things look better after the parting from Lloyd’s. North of England came out of hull & machinery, and now they have just announced that they are coming back into the market. Perhaps this time it could be good timing. More recently we saw Standard Club exit from hull & machinery and Lloyd’s completely, which had a substantial impact on the club”, said Vullo.

However, he warned that, if the Clubs could not increase rates, they would be forced to find income from elsewhere. “Therefore we feel that diversification is inevitable. “

Although clubs at the moment were, generally speaking, cash-rich, on balance they were rate poor, which is why Gallagher thought that the hardening market would be a three-to-four-year challenge.

Vullo put forward the “optimistic scenario”, which would consist of a bounceback in the markets, lower trade levels (due to Covid-19) and therefore lower claims, all combining to generate another increase in free reserves this year. However, Ingles put forward the counter-view.

“I’m the negative accountant of course. I don’t share the optimism of the market recovering enough. There’s approximately $650m to $700m investment income in 2019-20 that at the moment looks likely to reduce to nil. Therefore there is an awful lot of improvement needed in the technical result to get back to break-even, still less increase free reserves.”

Ingles continued: “We all know that the Clubs have what we might call “hidden” free reserves and they could use these to create a semblance of a profitable year, but I don’t think it’s going to be in their better interest to show yet another increase in free reserves if they are trying to seek a general increase (for 2021-22) of any substance.”

Tomorrow: Whither the General Increase? Claims History, Claims Future.