Motor accidents and mortality improvement

Improvements in insured life mortality have largely been taken as a given over the last 100 years. There have been some signs that this mortality improvement has been slowing, or halting over recent years.

I've been wondering whether the dramatic fall in motor vehicle accidental deaths is part of the story.

Despite the scepticism that some of the road safety initiatives have attracted, it is hard to deny that, overall, the road safety campaigns have been a fantastic success.

Vehicle accident mortality per 100,000 population has dropped by around 80% since the the 1970s, from a rate of 28.95 in 1970 to a provisional rate of 6.48 in 2009. This is the result of better roads, safer cars and law enforcement. The fatality rate per 100,000 cars has dropped even more as the number of cars has increased faster than the population, making the overall reduction even more remarkable.

This is a great boon for society. As a child I remember families we knew devastated by young people killed in car accidents, but this is much rarer these days

The implications for insurance  is that a good deal of the last few decades mortality improvement has come from is source, and that even eliminating traffic deaths completely (which isn't going to happen) wold only give a quarter of the improvements from this soure to date. This is particularly important for insurers as accidents make a higher proportion of younger deaths and disablements than at older ages. Also, many of the medical breakthroughs that are driving overall mortality improvements are in diseases that strike at older ages where insurance is less common. 

Insurers, particularly reinsurers and group insurers should be cautious about assuming future mortality improvements in their long term pricing.

 

To see the quite remarkable statistics: RTA fatality rates 1909 to 2009

http://www.abs.gov.au/ausstats/abs@.nsf/previousproducts/1301.0feature%20article412001opendocument&tabname=summary&prodno=1301.0&issue=2001&num=&view=

http://www.abs.gov.au/ausstats/abs@.nsf/Lookup/by%20Subject/1301.0~2012~Main%20Features~International%20comparisons~191

 

 

The perils of a too high return on equity target

One of the key decisions that businesses make is setting their hurdle rate for new investments. This is, however, trickier than it appears.

It is obvious that the hurdle rate has to be higher than the risk free rate in order to reward shareholders for the risks of operating a business, but how much higher than this should the margin be set?

It can be a particular problem for businesses that currently have very high returns on equity. In their case, even very high hurdle rates can be lower than their current ROE. This would mean that its ROE will drop over time raising concerns with analysts and investors.

It is worth reflecting on why a company might have a very high return on equity:

• It might, like Australia’s major banks, have substantial goodwill built up that it is not reflected on the balance sheet. This includes customer relationships, skilled staff, strong brands and such. Pharmaceutical and software companies can also be in a similar position.

• It might be in an industry which requires little capital to be employed, such as investment management, or providing a service, such as consulting.

• Its industry may be enjoying a temporary boom, allowing higher than normal prices to be charged.

This illustrates that very high ROEs are usually the outcome of unusual and not easily replicable circumstances.

So what are the implications of a very high hurdle rate?

• Projects will leverage off the existing good will to earn a high return on capital. This will mean that the company will stick to its knitting and be highly focussed. This may result in the company not diversifying or becoming vulnerable to a single market shift.

• Projects will be risky, as only by taking a high level of risk can the return on capital be met. If returns are not properly adjusted for risk, then increasing the risk taken on increases the expected returns. This means that, over time the business as a whole becomes riskier and its result more volatile. One way in which risk can be increased is to use gearing to reduce the required equity and enhance returns.

• Business cases get fudged. In order to get approval for a business case the figures get quietly fudged. This is done by either not fully reflecting the costs of the project ,often by underestimating or ignoring cost impacts on other parts of the business, or by overestimating the revenue impact, which can reflect complete overestimation of sales or perhaps including sales that would have been made in any case but credit them to the initiative. Another way of enhancing the numbers is to understate the equity required, for example by using a lower regulatory capital requirement, rather than a more realistic economic capital requirement.

• Sensible initiatives offering good risk adjusted returns don’t even get proposed to management as people don’t think they’ll get approved, so why bother putting together a full proposal.

Over time, these factors can seriously distort a business as the business initiative portfolio can, cumulatively have a major impact on the risk, return profile of the organisation as well as creating a more cynical, political view about business case proposals and their approval.

 

Problems in Risk Management - Lack of Historical perspective

One problem with risk management is that it often lacks historical perspective. The models produce very precise probabilities of failure, usually reassuringly small, but the model and its calibration don’t really mean anything.

In the last century and bit we have had:

• Two world wars,
• Numerous other wars,
• Four global banking crises,
• A great depression,
• Many other recessions
• Oil price shocks,
• Numerous real estate and stock market bubbles,
• Many advanced economies basically wiped out by war (Germany has been ruined at least three times in the last hundred years despite being one of the richest economies in the world)

Each of these events had devastating financial consequences, but I do not see risk management reports considering these sorts of events. Often the mathematical models gave very low probabilities of ruin, say one in two hundred years. However, if we examine the actual history of the last two hundred years, would the company’s risk settings have survived the 1890’s banking crash, two world wars, the Great Depression, the 1970’s oil shock and inflation or the Japanese lost decades?

Directors and others involved in the risk management process should ask these questions?