News
Lessons learnt? Have non-life insurers just been lucky... - 2009-09-30
Non-life insurers have emerged relatively unscathed from the financial crisis; was it luck, or have they learnt the lessons from their own spirals of the '80s and '90s? Neil Coulson looks at the evidence...
While banks have been going through their traumas, general insurers have been looking on from the sidelines from a position of relative comfort. Obviously there are some that took a more risky approach to the investments they held or underwrote policies that were linked to the banking crisis and suffered the consequences, but for most, the experience has been relatively painless. Indeed, within the UK stock market, general insurance was the only segment that increased in value during 2008.
Is this a reflection of the fact that general insurers have learnt lessons from the past and as a result of good risk management are able to avoid or contain the impact of economic shocks to their balance sheets, or is it just good luck with perils still lurking for unsuspecting insurers?
Have some of the issues that have caused major problems to the London insurance market in the past truly been addressed and gone away? Those tended to fall into three main categories:
Poor underwriting pricing, through competition or delusion, as demonstrated by the Lloyd's losses of around 20 percent of capacity in 1999 despite an absence of hurricanes.
- Poor risk management, not knowing what exposures are being underwritten, as demonstrated by reinsurance spirals.
- Poor reserving, inadequate processes or not recognising latent issues, as demonstrated by asbestos claims.
These three deficiencies combined in the reinsurance spiral, where reinsurers reinsured other reinsurers' books of business. This happened to the catastrophe excess of loss reinsurers in the late 1980s and was repeated in the 1990s when a personal accident spiral emerged in respect of US workers compensation business. These effectively became large games of pass the parcel with most of the participants having no idea how many layers of wrapping were involved before they got to the end and could no longer pass the package on.
Poor pricing conditions tempted reinsurers to seek new opportunities to find attractive risks. However, these new risks were different to the existing business and the pricing only appeared attractive because the risks written were not understood. As a result the low prices being quoted enabled a large volume of reinsurance to be purchased cheaply, increasing sales and magnifying the gross exposures.
Once the risks had been underwritten it took a long time for reserves to be correctly established as the understanding of the underlying risks was poor and the nature of the spiral was that the losses took a long time to emerge.
The absence of similar spirals in the noughties could be attributed to improved governance and risk management as lessons were learned from the bitter experience of the previous two decades.
Probably the greatest control to be introduced was that reinsurance contracts now typically contain exclusions for assumed reinsurance risks. Other controls in place include improved governance and risk management processes, such as a focus on assessing aggregate exposures. The 9/11 US terrorist attacks also taught insurers that aggregations could arise across different risk classes.
The Internal Capital Assessment (ICA) regime introduced by the UK regulator the Financial Services Authority helps ensure a proper understanding of exposures underwritten, while Lloyd's Franchise Board has a particular focus on ensuring the market manages the aggregation of exposure across its many syndicates.
Toxic losses
Latent losses related to asbestos and pollution were another source of claims that nearly brought Lloyd's to its knees in the late 1980s and caused the demise of a number of other insurers.
Equitas, which is now effectively reinsured into Berkshire Hathaway, has swept up the old Lloyd's losses from this source and although there continue to be large settlements for asbestos and pollution claims around the world they now seem to be within reserving levels. The pollution exclusions that have been prevalent in most insurance policies for a number of years have helped to control insurers' exposure. However, the restraint shown by most governments around the world from embarking upon massive pollution clean-up campaigns - which they then seek to recover the costs of from the private sector - has also been an important factor in limiting fresh claims.
The next wave of latent claims is likely to come from either totally unknown or newly emerging sources. The ultimate impact of these claims will be significantly influenced by the approach adopted by governments and courts.
But insurers can also protect themselves where foreseeable with exclusions for risks related to hazards such as pollution, nuclear and tobacco. And they can potentially constrain the downside of newly emerging risks by ensuring policies are on a claims made basis, so that if a new source of claim emerges policyholders cannot claim against several years' policies, magnifying an insurer's exposure.
There is increasing awareness of potential sources of new claims, as the likes of Lloyd's and the research arms of brokers and reinsurers release publications on emerging risks such as from pandemics, hormone replacement therapy and nanotechnology. There is also pressure from regulators for insurers to consider emerging risks within their risk management and reserve setting and it is likely that such considerations will play a part of any Solvency II assessment of reserves.
Unknown unknowns
Despite this, "unknown unknowns" are by their nature difficult to allow for until they become tangible and there will always be the risk of new classes of claims emerging. The improved awareness of the issue, increased background research and more thorough reserving processes should accelerate the identification of - and response to - latent losses.
The increased role of actuaries in the reserving process over the last 20 years has helped general insurers avoid under-reserving. The quality of reserving processes has improved significantly at most insurers - and been further enhanced by the challenge to methodologies the use of external actuaries brings. It is now a lot more difficult for an insurer to put off facing up to increasing levels of claims.
Measures to ward off suicidal pricing are not as easy to entrench as it is often not in the instinct of underwriters to just say 'no' to business. The controls for this are good governance, management information and risk management, but market conditions probably remain the biggest influence.
Typically management put tools in place outside of the underwriting teams to ensure risks are priced in conjunction with estimates of realistic potential loss levels. If good controls are in place to ensure that the pricing levels agreed by management in their planning processes are adhered to this should prevent suicidal pricing. However, loosening of terms is often more difficult to monitor.
Other controls have also been introduced on a more ad hoc basis, such as the Franchise Board challenging the Lloyd's market to take a close look at the pricing of energy risks. The ICA and Solvency II processes should effectively force insurers to recognise deteriorating market conditions within the level of capital required each year, which should help to ensure there is sufficient capital to absorb increased risk of losses, but also act to reduce the amount of business existing capital can underwrite.
This in turn should help to focus management on identifying whether their potential return on capital is likely to be acceptable and the level of capital they wish to commit to a weak market.
So, while it appears that insurers have learnt their lessons and are in relatively good shape at managing their risks, the quality of risk management is variable and there are still traps out there for the unwary.
Neil Coulson is a partner in Littlejohn's financial services team. Contact Neil on 020 7516 2270 or email ncoulson@littlejohnllp.com
This article was first published in Insider Quarterly, Summer 2009.
