We assess country risk as high because we expect GDP contraction of 3.6% in 2015 and project that the economy will expand by only about 0.4% annually in 2015-2018, below the average for the previous four years of 2.4%.
We also consider that Russia's weak political and economic institutions damage the economy's competitiveness and business and investment climate, and we view its payment culture and rule of law as weak.
Our moderate industry risk assessment remains positive for the overall assessment. The profitability of the market (measured by return on equity [ROE]), product risk, and barriers to entry all support this assessment, while market growth prospects and the institutional framework are negative factors.
We have revised our assessment of market growth prospects to negative, reflecting our expectation of negative real growth of the insurance market in 2015 and 2016, and unclear prospects that growth will pick up, given significant macroeconomic uncertainties.
We see some positive steps coming from the Central Bank of Russia (CBR), acting as a megaregulator, but we would seek a stronger regulatory framework, longer track record, and greater consistency to revise our assessments of the regulatory framework and track record.
We believe that negative factors could develop, which could affect our assessment of insurance industry and country risk for the Russian P/C insurance sector in the next 12-18 months. We note negative developments in Russia's sovereign creditworthiness, reflected in our negative outlook on the long-term sovereign ratings and the negative trends we see for economic and industry risks in our Banking Industry Country Risk Assessment (BICRA) for Russia. We are also monitoring developments that could further depress profitability in the insurance sector.
What about insurers' profitability?
We generally anticipate that the insurance sector will prove to have been profitable in 2015, with profits largely supported by high investment income amid the high interest rate environment that persisted during the year, and positive foreign exchange revaluations. However, we also note that profitability in some lines has dropped (in particular motor risks), making technical results for some players negative.
We believe that the sector's profitability in 2016-2017 will be under pressure as investment profits will reduce and technical performance could further deteriorate.
Russian insurers are exposed to higher economic risks than their international peers
Historically, Russia's insurance market has been volatile and dependent on economic factors. Consequently, we expect the P/C insurance sector to decline in 2016 in terms of gross premiums written (GPW). Nominal growth for 2015 is likely to be 5%-7%, mostly because of growth in obligatory motor third-party liability (OMTPL) business. However, we think real growth will be negative.
We believe that Russian insurers have accommodated to a weaker Russian ruble against the U.S. dollar, the euro, and the Japanese yen. While the rising cost of imported spare parts continues to put loss ratios in motor insurance under pressure, the strain has reduced since the beginning of 2015. We note that additional foreign currency volatility could be still painful for insurers, especially for companies engaged in motor insurance.
In our view, high inflation will continue to add to growing losses (15.6% in 2015 and 7.6% forecast in 2016).
We view the payment culture and rule of law in Russia as weak. Russia has a low ranking in the World Justice Project's Rule of Law Index. Insurers' balance sheets show a significant volume of accounts due from debtors (approximately 20% of total assets as of June 30, 2015). We note that the total amount due from debtors is increasing. Payment discipline -that is, willingness to pay in a timely fashion--for these amounts has been low.
Return on equity - neutral
We regard the profitability of the Russian P/C insurance market as neutral to our assessment. We understand that the sector will be profitable for 2015. Profits were likely supported largely by high one-off investment income amid the high interest rate environment, which persisted during the year, and positive foreign currency revaluation after sharp ruble devaluation in December 2014. We note, however, a continued negative trend in technical profitability. In particular, CBR data as of June 30, 2015, shows that OMTPL insurance shows a combined (loss and expense) ratio above 100%, even after significant tariff increases in 2014 and 2015.
Based on our data, the sector's five-year weighted-average ROE is approximately 16%. While we expect investment results to support it in 2015, we also expect the five-year weighted average ROE to deteriorate in 2016, under pressure from growing loss ratios. We note that specialized corporate insurers and insurers that are part of banking groups focusing on personal accident insurance have above-market-average ROE, while motor insurers have weaker returns. For all players, ROE is suffering from inflation and high acquisition costs. In particular, in the OMTPL and motor hull segments, we expect ROE will decline in 2016. These segments form about 37% of the Russian insurance market. The profitability of these lines is threatened by continued competition and still-high acquisition costs. We believe that adverse court practices continue to facilitate losses, but to a lesser extent than in 2014. The improvement in this trend can be attributed to the agreed methodology on OMTPL loss calculation introduced by the CBR.
Recent changes in the law on OMTPL have increased limits of coverage and tariffs, and introduced many technical changes in the way claims are settled. So far, claims developments are negative and loss ratios are rising. The impact of increased life and health coverage limits has so far been limited.
We believe that the changes could significantly increase OMTPL loss ratios and could also increase the claims settlement period for that segment.
Except for ROSGOSSTRAKH RESO Garantia, few Russian insurers have debt. As a result, the sector's ROE is not significantly influenced by leverage.
The average combined ratio for the top 20 companies is close to 100%
Nevertheless, deviation from this average can be very high, varying from about 70% to almost 130%. The combined ratio is the industry's most closely watched underwriting profitability metric; the lower the combined ratio, the more profitable, and a ratio above 100% signifies an underwriting loss.
Product risk - neutral
We assess the potential for product risks to trigger profit volatility in returns as neutral.
Russian insurers' portfolios show relatively low exposure to natural catastrophes, and the volume of catastrophe insurance is insignificant. Although about 25% of Russia's land mass is exposed to catastrophe risk, only 10% of the population lives in potentially affected areas. The potential for earthquakes in the Far East and droughts in Russia's southern regions to cause losses is limited by the low insurance penetration.That said, motor portfolios are more open to claims in regions prone to hailstorms and floods, such as Moscow and Moscow Oblast (where about 7 million cars are registered) and St. Petersburg (about 1.8 million cars). In addition, we observe that only a few insurers--those with more advanced risk management frameworks-buy reinsurance protection against catastrophe risk. This heightens the industry's vulnerability to weather-related events.
Products sold in Russia have moderate asset-liability mismatch risks, and claims are generally resolved within a year of the claim period.
We note that, despite existing sanctions, reinsurance protection remains available for Russian insurers. We understand that the government reinsurance company project currently under discussion should provide capacity for risks which are not accepted by the international reinsurance market.
Insurers covering motor risks are still exposed to legal claims, increasing the scope for unpredictable liability settlements in motor risks. Court settlements of motor insurance claims have tended to be adverse for insurance companies and have allowed for more generous settlements than specified in insurance contracts or anticipated by insurance companies in their motor hull and OMTPL policies. We believe that the situation with court claims remains uneven across the country, and we understand that in some Russian regions it has led to significant underperformance of motor portfolios. We also believe that the largest companies-the market leaders--have taken measures to streamline the payment process to reduce court cases. In some instances, we note that companies have significantly reduced their exposure to certain regions. We also believe that recent changes in OMTPL insurance are reducing the number of court cases. We note, however, that claims development related to claims on life and health under OMTPL could develop rather unpredictably.
Barriers to entry Russian P/C insurance sector are moderate
Regulatory practices are not exceptionally demanding, although the process of registering a new insurance company or getting a new license can be lengthy. Interested parties may enter the market easily by buying a small insurer that is already licensed. That said, such deals occur infrequently, mainly because small Russian insurers typically lack the transparency and size a would-be purchaser would prefer, while sellers are generally seeking to sell at very high prices. On the other hand, as a result of poor profitability, mostly in motor lines, several companies have decided to leave the market or close their retail operations.
For example, RSA Insurance Group decided to dispose of its asset in Russia -Intouch Insurance. MUNICH Re revised its regional strategy and decided to close its representative office in Russia. ZURICH and AIG decided to wind up their retail businesses in 2014. ALLIANZ slashed the premium it wrote further in 2015.
Some large European insurance groups are maintaining a presence in the market, however. ALLIANZ and SCOR Re operate as separate companies, while AXA has a minority holding in RESO Garantia, and GENERALI has a minority stake in INGOSSTRAKH.
Given the current environment, we are not expecting any new entrants to the market.
Our assessment of the sector's operational barriers takes into account distribution's important role in achieving successful market penetration, the difficulty involved in establishing and building viable distribution relationships and networks, and concentration in the market. The top five companies cover 48% of the market, based on GPW, and the top 20 handle about 77% of GPW in the first half of 2015.
Considerable operational barriers stem from the Russian market's sheer vastness. Moscow and St. Petersburg account for 58% (based on the first half of 2015) of the aggregate market premium because penetration in these cities is three times higher than the Russian average. Building a franchise in these cities would be difficult, however, because competition is so intense. The limited availability of qualified staff also inflates personnel expenses.
Market growth prospects - negative
We have revised our assessment of market growth prospects to negative from neutral. We expect insurance premiums to reduce in 2016 in nominal and real terms. Given the volatility of the macro environment, it is hard to forecast beyond 2016.
We believe that the increase in OMTPL tariffs that has supported market growth over 2015 will have only limited impact on 2016. We think the OMTPL premium will likely be flat at best year on year. Motor hull, which already experienced a sharp decline (-15% expected for 2015) is unlikely to revive, as car sales are expected to stagnate after a sharp decline in 2015 (forecasted -40%). Retail clients' disposable income is not growing, forcing them to reduce spending on insurance policies. This trend is made worse by the increase in the average size of premiums (15% growth in motor hull) reflecting sharp ruble devaluation and increase in car prices in the beginning of 2015. As retail lending is not expected to grow in 2016, it is unlikely to support the personal accident insurance line.
Overall, we believe that the declining disposable income of the Russian population and corporate clients' saving on insurance expenses will only add to this trend.
At the same time, the low level of insurance penetration in the Russian P/C market indicates good prospects for long-term growth; that said, we do not expect it to pick up soon. Insurance penetration is a measure of an insurance market's maturity and development and is calculated as the average premium paid per person. Penetration is at approximately USD 150 of premium per person in 2015, which we see as modest. The average across Europe is about USD 800 and in North America is above USD 2,000.
P/C insurance premiums as a percentage of GDP averaged about 1.2% over the past five years. This is similar to the penetration levels we observe in Turkey, Mexico, Serbia, Bahrain, and Tunisia, but significantly lower than in North America and Europe. Taking into account the expected decline in premiums in 2016 and small GDP growth, we expect penetration to decline slightly.
We believe that negative demographics, such as Russia's aging population, low income levels, and low awareness of insurance products and services contribute to structurally weak demand. These factors will likely remain a drag on industry growth.
Institutional framework at high risk
We regard the Russian insurance institutional framework as high risk, based on our assessment of the regulatory framework as weak, the regulatory track record as intermediate, and governance and transparency as weak.
Most regulatory initiatives are very much rule-based. The regulator does not yet perform consolidated analysis of financial groups. Examples of regulatory forbearance are becoming rare, in our observation.
We view the regulator's decision to move to new accounting rules in 2016-2017 positively, as it would allow more frequent reporting and oversight. We also see that the regulator now has tighter control over asset allocation via a system of specialized depositaries.
The number of insurance companies has decreased tremendously from the early 2000s, when more than 1,000 insurers participated in the market. This reduction has been influenced by the regulator's efforts to withdraw licenses. There will be about 360 companies operating in the market by the end of 2015.
We do not expect a significant change in this landscape, but we think the number of companies will diminish, both organically and through license withdrawals. We note that the number of licenses withdrawn is large (about 50 licenses for the first half of 2015). We also note that several licenses were suspended in 2015 (technically allowing insurers to resume their activity once all violations are corrected). We understand that at least another 90 companies are at risk (as they are classified by the regulator in the higher-risk category).
Our overall negative view of governance and transparency is supported by the findings of Transparency International, which measures the perceived levels of public sector corruption in 175 countries around the world. Russia ranked 136th in Transparency International's Corruption Perception Index in 2014, 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.
Standard & Poor's Rating Actions are determined by Ratings Committee. This commentary has not been determined by Ratings Committee. The opinions expressed in this article do not represent a change to or affirmation of Ratings Services' opinion of the creditworthiness of any entity/entities (named or inferred) or the likely direction of ratings.
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