JEDDAH: Domestic insurers in Saudi Arabia have seen their business expand very quickly in recent years as health insurance has become widespread. Once it became mandatory for expatriate staff in 2008, medical insurance spread to domestic employees, and is now the biggest line of business in the Kingdom. Compared with insurers in Western markets, insurers in the kingdom tend to focus more on achieving a return on equity through underwriting alone. Investment strategies are conservative, and contribute little to the industry's overall good profitability. But as competitive pressures increase, Standard & Poor's Ratings Services expects that it will be harder for companies to maintain underwriting discipline.
The Saudi Arabian Monetary Agency (SAMA), which regulates insurance in the Kingdom, actively aims to ensure the industry as a whole develops positively. While insurance penetration remains low as a percentage of GDP, it is growing fast and it is expected that as the economy grows, so will the insurance sector. SAMA rigorously enforces its requirements for reporting and disclosures, and demands that all insurance and reinsurance providers gain operational licenses and product approvals. Its processes create a barrier to entry for new participants, somewhat reducing the competitive pressures caused by the presence of 33 insurers chasing a fairly small, if growing, market. Despite these strengths, the overall institutional framework has yet to be tested under stress.
Low interest rates present Saudi insurers with a particular problem. Because they operate in an Islamic country that adheres to Shariah law, all insurers must pay a "zakat" tax on their investments, including 2.5 percent of the value of their cash investments. S&P estimates that at year-end 2010, KSA insurers paid zakat of approximately SR190 million, while their aggregate investment return was just SR159 million (about 2.1 percent). Therefore, until interest rates rise from their current low levels, Saudi insurers must make an underwriting profit to break even, according to Standard & Poor's.
Return on equity
S&P regards the profitability of the Saudi insurance market as positive. According to data from SAMA, the weighted-average return on equity (ROE) over the past three years has been approximately 13 percent. ROE benefits from strong underlying underwriting profits. The overall loss ratio stands at 69 percent and the net combined ratio at 87 percent.
Generally, the Kingdom's insurers maintain large capital bases that constrain their ROE. Many of them hold shareholder's equity balances on their balance sheets that S&P considers large, given the amount of premium they currently write. Thus, return on equity is reduced by the large denominator.
Low interest rates mean very modest returns on bank deposits -- currently just 0.7 percent a year. Thus, for Shariah-compliant insurers, the obligation to pay zakat tends to limit the underlying ability of earnings to enhance capitalization. Saudi Arabia levies zakat at a flat rate of 2.5 percent on cash holdings. S&P estimates that the overall zakat payment for Saudi insurance companies at year-end 2010 exceeded their overall investment returns by approximately SR30 million. However, as underwriting earnings or investment returns increase, the zakat payment will consume a decreasing proportion of the companies' profits.
Product risks
S&P assesses the potential for product risks to trigger ROE volatility as moderate. Products sold in the Kingdom have relatively predictable claims settlements and limited asset/liability mismatch risks. Most of the business written in the Kingdom is short-tail -- claims are usually made during the term of the policy or shortly after the policy has expired. Therefore, there is little uncertainty relating to claims amounts and payment patterns. The Kingdom is not overly litigious, and S&P sees limited scope for unpredictable liability settlements.
Short-tail business also means low exposure to asset/liability mismatch risk. Insurers' balance sheets show no material long-term liabilities, so the short-term bank deposit assets that comprise most of the investment portfolios are broadly aligned with the duration of their respective liabilities. Most claims are settled quickly.
However, some lines and regions have moderate exposure to natural catastrophe risks. While exposure to natural catastrophe risks is low across most of the Kingdom, damaging earthquakes can occur in the western Jeddah region. Although this region is near a major plate boundary in the Red Sea, S&P considers earthquake risk to be relatively remote. PreventionWeb, a UN project that facilitates the sharing of information on disaster risk reduction, ranks Saudi Arabia 105th out of 153 countries in terms of earthquake exposure.
Jeddah, the second largest city in the Kingdom, has a population of about 3 million people and is prone to severe floods. In 2009, floods caused over 100 deaths and economic damages to infrastructure and homes estimated by some at nearly $1 billion. Floods also occurred in December 2010 and January 2011.
The country is also exposed to potential civil commotion losses, particularly in the Eastern Province. Geopolitical risks are elevated as the Gulf region is the source of much of the world's oil supplies.
Institutional framework
S&P regards the institutional framework as a neutral factor for the industry. This is based on assessment that oversight is moderately strong, and transparency and governance are adequate.
SAMA and the Capital Market Authority (CMA) exercise moderately strong regulatory oversight. They enforce it by requiring quarterly reports and disclosures, and by licensing each insurer and approving all products. However, the overall institutional framework is not seasoned and has yet to be tested under significant levels of stress. The new framework provides order to the market, enhances consumer protection, and prohibits anticompetitive behavior, such as dropping rates. SAMA rigorously enforces rules and regulations and has the authority to withdraw licenses if insurers consistently fail to comply with those regulations. That said, the regulator is actively engaged in dialogue with all of the market participants to ensure that the industry as a whole develops positively.
Transparency is adequate. S&P views accounting as broadly transparent. SAMA requires that all insurance companies prepare their financial accounts in accordance with International Financial Reporting Standards (IFRS). Companies report results on a cooperative basis, and thus have separate income statements and balance sheets for policyholders' funds and shareholders' funds. Standard & Poor's combines these statements in our analysis. Financial accounts are required to have at least two independent external auditors. Quarterly accounts are also obligatory and are available on the Tadawul stock exchange website.
The adequate level of transparency is confirmed by Transparency International, which measures the perceived levels of public sector corruption in 178 countries around the world. It ranks Saudi Arabia 50th in its Corruption Perception Index, which is calculated based on surveys conducted among country experts (such as the Economist Intelligence Unit, Freedom House, the World Bank, and others), as well as countries' business leaders.
Corporate governance is sufficiently strong. SAMA requires companies to have independent board members, approved by SAMA. It also mandates the use of external consultant actuaries and the appointment of risk managers, which further strengthens the governance framework.
The regulator
The Saudi market underwent significant change in 2008, following a royal decree that required all insurance companies to be domiciled in the Kingdom and to comply with new regulations that created significant regulatory, economic, and operational hurdles to establishing new insurance companies. The high barriers to entry protect existing market participants from new entrants to a certain extent, and thus mitigate the negative pressures of increasing competition as the market becomes more crowded.
As the regulator, SAMA has developed a rigorous process for approving new licenses for insurers. Its regulations impose requirements for all insurers to develop a credible business plan to gain a license to operate, to be publicly listed with a wide shareholder base, and to publish audited financial accounts. The regulator exercises a substantial level of authority over the market participants, and in the long term aims to foster and develop a successful insurance industry. As a result, all KSA insurers are now publicly listed and at least 40 percent of the shares in each were sold through an IPO listing on the Riyadh Tadawul stock exchange.
Insurers also suffer moderate operational and legal barriers to entry, in our view. Operational barriers include the need for local offices. Many of the insurance companies are well represented in the three key cities of the Kingdom -- Riyadh, Jeddah, and Dammam -- but are still expanding their distribution networks to other cities and more remote areas of the Kingdom. This process requires time and resources.
A lack of qualified technical staff in the local market, especially at the senior management level, presents another operational hurdle, as does SAMA's requirement that at least 30 percent of staff be Saudi nationals. As few Saudis know about or show an interest in insurance, the staffing requirement can be a major concern for new insurers in the Kingdom; they could incur the additional cost of having to train up the required number of local staff.
There are also moderate legal barriers -- newly established companies have to comply with the Capital Market Law for an initial public listing, namely submit proper documentation and gain approvals from the CMA.
Despite all the hurdles, the Kingdom's marketplace now has 33 licensed insurers and one licensed specialist reinsurer. Perhaps a further half-dozen insurers are still working through the set up process.
Overcrowded market
Many of the insurance companies operating in the Kingdom are recent start-ups with low or zero premium volumes. The marketplace is crowded and getting ever more competitive. Most energy business risks are ceded outside of the Kingdom and therefore domestic insurers have little access to the petroleum sector, which accounts for roughly 80 percent of the Kingdom's budget revenues, 45 percent of GDP, and 90 percent of export earnings. The state-owned monopoly Saudi Arabian Oil Company (Saudi Aramco), in particular, cedes its energy risks to its captive Stellar Insurance Ltd. (AA-/Stable), which is domiciled in Bermuda.
As a result, too many companies are chasing the same few profitable risks, which places rates under significant downward pressure. Bearing in mind the importance of underwriting profitability in a Shariah-compliant market, soft pricing conditions hinder companies' profitability. The market reported a 96 percent net combined ratio for the first half of 2011, indicating that technical profitability has deteriorated slightly compared with prior years.
Penetration is low
S&P views the insurance penetration trend in Saudi Arabia as positive. It has nearly doubled to over 1 percent of total GDP in 2010, from 0.53 percent in 2006. SAMA also calculates penetration as a proportion of nonoil GDP (up to 2.08 percent in 2010 from 1.15 percent in 2006).)
S&P expects growth to fall to around 10 percent annually over the next five years. Average premium per capita remains modest, at approximately SR600 (or $160) compared with an average of about $1,900 across Europe and $4,000-$5,000 in the mature markets of Western Europe.
Economic growth
As the insurance market continues to grow, the pressure caused by the overcrowding should ease. With more profitable business available, market participants will be able to expand organically without taking market share from their competitors.
© Arab News 2012
