Conduct risk has not been an issue for most U.K. motor insurers in recent years. While these insurers had attention from the financial press following the Ogden discount rate change in 2017, their banking counterparts have dominated the headlines when it comes to conduct. Over the past decade, the U.K. banking industry has paid out over $50 billion related to Payment Protection Insurance, and been fined millions for other failings such as misselling interest rate derivatives. Meanwhile, motor insurers have kept largely out of the Financial Conduct Authority's crosshairs. But things may be about to change; insurers looking to boost margins amid fierce competition and poor investment returns have been increasingly topping up their revenues by other means. Here, we look at four major U.K. motor insurers' business models through a conduct lens, and assess the regulatory response so far and potential issues in the future.

Earnings Pressure For U.K. Motor Insurers

U.K. motor insurers returned to underwriting profitability in 2017 for only the second time since 1994 (according to "E&Y's Annual UK Motor Insurance Results"). While E&Y also expects 2018 to be profitable, it anticipates that the industry will return to negative underwriting results in 2019. In our opinion, poor underwriting performance is a result of intense price competition in the market, although claims inflation and fraudulent claims have also played a role. The rise of price comparison websites (see "European Motor Insurance Markets Are Not Swayed By The U.K. Price Comparison Revolution," published on Oct. 4, 2016 ) as the primary source of new business has led to a highly commoditized market where customers chiefly focus on the cost of cover. This has allowed new entrants to the market to build their market share through sophisticated pricing models and without significant investment in advertising or distribution. Conversely, traditional insurers that have priced ineffectively have struggled to maintain their market share or suffered the effects of adverse selection on their bottom line. As a result, many insurers have stripped back their motor insurance policies to the most basic levels of coverage or created low cost brands to attract consumers with their lowest possible price on comparison websites.

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At the same time, low interest rates in the U.K. since the 2008 financial crisis have seen non-life insurers' other main income stream, investment return, shrink. Typical investment yields since 2008 have been 2%-3%--rarely enough to make a significant profit. Due to regulatory capital charges, insurance companies have had limited ability to increase credit risk or invest in alternative assets to generate a higher investment return.

Rise Of Non-Traditional Income Streams

In response to narrowing underwriting margins and slender investment profits, we have seen motor underwriters increasingly turn to other sources of income to maintain levels of profitability. For the four largest listed U.K. motor insurers-- Admiral, Esure, Direct Line Group, and Hastings--some of the most common income sources include instalment income, fees and charges, and so-called ancillary income (see charts below for a breakdown of these insurers' three-year average profits).

Instalment income (or premium finance) relates to the interest charged by an insurer to customers who pay by a monthly direct debit rather than in an upfront payment. Virtually all motor insurers now give customers the option to pay by instalment; GoCompare (a price comparison website) estimates that over 38% of policyholders now pay their insurance via monthly instalments. It is particularly attractive to younger drivers who generally pay a higher premium for insurance (analysis from the Association of British Insurers shows the average cost of insurance for drivers aged 18-21 is close to £1,000) and would struggle to pay for their insurance in a lump sum. However, the cost of paying monthly is high, with motoring magazine Auto Express estimating that some drivers pay 20% more when paying monthly rather than as a one-off payment. As of July 2018, the annual percentage rates (APRs) used by Swiftcover and Swinton were close to 35%.

Fee income has been another significant source of income for motor insurers in recent years. This relates to the amounts insurers charge for various services in relation to their policies such as administration fees for adjusting the policy (for example changing address or car), or cancelling it. The market shows significant divergence in the costs of providing these services. As of January 2018, NFU Mutual and Direct Line for example, were not charging for altering policies and NFU was one of the few insurers not charging a fee to cancel a policy. On the other hand, as of January 2018, Esure charged up to £26 to alter a policy and Zurich £50 to cancel a policy.

Ancillary insurance products relate to additional insurance cover that can be added to the main motor policy. These most commonly include: legal expenses in the event of a court case; personal accident, where compensation is provided if the policyholder is injured; and the cost of replacing lost keys. These polices are sometimes underwritten by the insurer themselves or by a third party who pays the insurer commission.

Admiral

Admiral is one of the most profitable motor insurers in the U.K. market. The group regularly records return on equity around 50%. Of the four largest U.K. insurers, Admiral has the highest percentage of profits generated by U.K.-based underwriting (including profit commissions from reinsurers this rises above 50%). However, the group's instalment income (£55 million compared with £403.5 million profit before tax in 2017) and in particular fees and additional products make up over 64% of profit before tax (international insurance, finance costs, and other costs bring the figure back to 100%).

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Esure

Esure's gross income from premium finance and fees equates to over three quarters of the group's profits before tax (PBT). If we net off non-underwriting costs against this income, the percentage remains substantial at close to 60%. The group depends the most on premium finance income out of the four. This perhaps reflects the 27.4% APR Esure charges customers to pay in monthly instalments. The insurer also makes substantial returns from claims income (from the appointment of firms in the claims process) and income from non-underwritten services.

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Direct Line

While Direct Line is the dominant player in the U.K.'s home and motor market, it also offers commercial insurance and a rescue service, which contribute to its bottom line. Overall, Direct Line generates 45% of three-year average profits before tax from underwriting. Investment income still makes up a significant portion of the group's profits with a three-year average of 39% (by far the highest of this cohort--Direct Line--holds more investments outside of cash and money market funds than Admiral, Esure, and Hastings). While traditional sources of income still make up a significant portion of profits, non-traditional income streams make up over a third of the group's average profit before tax, with instalment income representing the majority of this.

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Hastings

Hastings differs from the other three insurance groups as it is operates both as a broker and an underwriter. It is therefore difficult to provide a relevant peer comparison to Hastings, as brokers, rather than underwriters, generate many of the non-traditional sources of income. However, looking at the group as a whole, it is clear that instalment income, fees, and ancillary income contribute significantly to overall profits. We note that fees and commissions will also cover income received for policies underwritten by third parties.

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Heightened Conduct Risk?

While these sources of income have helped boost earnings in a market that has struggled to maintain underwriting profitability they will, in our opinion, also lead to an increased risk of regulatory scrutiny and perhaps, ultimately, intervention.

The profits made by insurance companies from instalment income have come under attack from critics. Consumer groups and newspapers have accused insurance companies of charging high APRs that disproportionately affect lower income customers and younger drivers. Paying insurance via monthly instalments is particularly popular with young policyholders, who on average pay significantly higher insurance premiums, and with lower income households, who may be less able to pay a one-off sum compared with those on higher incomes.

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The FCA addressed the issue of instalment income in a thematic review published in 2015. The review highlighted the information gap for customers between quoted premium prices and the total cost of paying by instalments. The FCA stated that it would follow up with firms to ensure this and other informational shortcomings were addressed. Issues around affordability and specific demographics were not mentioned in the report, however in our opinion, a period of sustained increase in premium rates could bring these areas into sharper focus for the regulator.

Administration and cancellation fees have come under similar levels of criticism, with consumer groups and even the BBC's watchdog show covering the issue. The main complaint has been a lack of justification for such large fees for what appears a relatively simple service. In March 2017, the FCA reported that it had delved into the fees charged by insurers and brokers. Again, the authority highlighted an information gap, that certain insurers and brokers were not providing the relevant information to customers or explaining how the fees were calculated. While the regulator said it had found a significant divergence in fees between companies for what were ostensibly similar services, we have seen no further action by the FCA.

Ancillary income from other products has had less attention from the media but the FCA is nevertheless paying attention; of the three areas covered in this article, the FCA is scrutinizing ancillary income the most. The authority published the findings of a general study into add-on products in 2012. The report found that consumers were purchasing products of poor value, overpaying by around £108 million-£200 million a year according to the FCA's estimation. Along with banning so-called opt-out selling (where customers have to actively opt out of buying additional products), the FCA sought to improve the level of information provided on these products. In 2017, the authority published its first report on add-on products in its "general insurance value measures pilot." This detailed the number of claims, claims acceptance rates, and average pay-outs. The data showed that on many lines the number of claims received by insurers were minimal. FCA views the pilot as successful, with Director of Strategy and Competition Christopher Woolard stating in 2018 that, "publishing the first set of data has incentivised insurers to make product improvements and focus more on overall product value."

The FCA May Take A Harder Line

The change in business model of U.K. retail insurers has been a success in terms of allowing them to continue to record profits when achieving pure underwriting profits is harder due to market dynamics. However, the changes have led to significant amounts of negative press for insurers utilizing these income streams. So far, no material financial losses related to conduct risk have crystallized. The FCA's approach has generally been to seek to educate the customer and ensure that firms provide the information required so their customers can make an educated choice. However, part of the FCA's remit is to protect consumers and "put their protection above the firm's own profits or income" so, in our opinion, the authority could take a harder line if insurers do not provide better customer value for money. Recently, the FCA announced it would be conducting a market study into pricing practices in general insurance firms following a super-complaint from Citizen's Advice Bureau surrounding, among other things, renewal pricing. While this action does not deal with non-traditional sources of income, it perhaps signals that the FCA may be taking a tougher stance on motor and home insurers. This could force insurers to revert to more traditional sources of income or revisit the transparency and pricing of ancillary products. While we are highlighting possible heightened conduct risk for U.K. motor insurers in this article, we do not expect it to have a rating impact over the next three years.