Risk Management Reports
December 2001, Volume 28, Number 12
It is not a
pretty picture. The global commercial property and casualty insurance business
may be unraveling.. Here is a recipe for disaster.
scrambling for cover. Zurich Financial sells its reinsurance facility (now
called Converium). Royal-SunAlliance suspends its reinsurance underwriting.
Reinsurers and insurers alike raise rates, add exclusions, reduce limits,
cancel and non-renew. US insurers complain bitterly about underfunding in the
Lloyd's Security Fund, after regulators permit a temporary reduction in that
fund from 100% to 60% of estimated losses. The US National Association of
Insurance Commissioners (NAIC) investigates the "solvency" of
Lloyd's. A group of chief executives march on
Is there a
role for the Federal government? In
How far do we
want to carry this? Are terrorism "pools" warranted by the attacks of
September 11? We've experienced few attacks in the past in the
What is the proper dividing line between the commercial markets and governments for risk financing? September 11 forces an answer to that question.
So much for the reactions of insurers and reinsurers. How are buyers reacting? They have lived with an increasingly irrational insurance market for over twenty years. They tolerated volatility, capricious underwriting, inadequate reserving, exorbitant expenses, tedious and short-changed claims payments, a quick rush to exclusions when conditions changed, and the offer of limits of protection insufficient for today's economic requirements. They tolerated the incomprehensible inability of the industry (underwriters and intermediaries alike) to produce a complete and correct contract before a policy's inception date, inexcusable in any other industry. The absence of agreed-upon wording for the World Trade Center insurance, even though the premium was paid months ago, contributed directly to the Swiss Re lawsuit. Now rates are sky-rocketing and coverage is shrinking. Consumers are not happy.
Already insurance buyers for larger companies are considering much higher retentions, expanded use of their own captive insurers, use of industry pools, and catastrophe bonds that tap capital markets. The French risk managers' association, AMRAE, accuses insurers of taking advantage of the situation in raising rates. AMRAE is working to obtain tax deductibility for self-insurance reserves and threatens the creation of a industry mutual company. Most companies, however, are simply ratcheting up their deductibles under insurer pressure. Few appear to be stepping back to look at the entire system.
Eight years ago, British Petroleum did just that. It decided to drop all commercial insurance in excess of US$10 million, allowing local operating units to buy statutory insurance up to that level on their own volition. This apparent topsy-turvy decision was based on a study by Neil Doherty of the University of Pennsylvania and Clifford Smith of the University of Rochester (see RMR July 1994), reported in The Journal of Applied Corporate Finance, Vol. XI, No. 5, Fall 1993. In effect, BP became fully self-insured. Most companies, of course, do not have BP's global spread of risk nor its financial resources.
Is this the time to consider the end of reliance on commercial insurance? The system, in operation for more than 200 years, depends on the ability of individual insurers to lay off their bets with reinsurers around the world. As long as the system demonstrates reasonable financial security, it works. Consider this scenario, however.. Under the pressure of a single monumental loss, or accumulation of losses, and compounded by decades of uncorrected bad habits, some reinsurers fail. Other in turn go bankrupt, creating a falling domino effect. Adverse publicity then triggers a public loss of confidence: why buy insurance if a loss payments are questionable? Governmental intervention becomes essential. Larger organizations can take the BP approach and consider other alternatives, but most of us, individuals and smaller businesses, require some insurance for our risk financing.
I exchanged emails with one risk manager about his retention levels. Even with a huge premium increase, his deductibles rose from $10 million to $25 million. What are his current insurance limits? They are less than half what his company charged off last year in credit losses! In ten years he has incurred insured losses of less than 1% of last year's credit write-off. Under these circumstances, is his insurance "material?" Couldn't he just as well adopt the BP approach? Using hypothetical numbers, let's assume that he has two risk situations. The first is credit risk, with an expected annual loss of $200 million and a possible "worst case situation" of $600 million. The second is operational risk, with an expected annual loss of $10 million and a possible worst case situation of $410 million. His company absorbs the first loss potential internally but chooses to "insure" the second. If it can manage the first, why can't it manage the second? What's the economic difference? Insurance advocates will argue that, for operational risk, there is a market with "reasonable" rates. But a market also exists to hedge credit risks, and we know the unreliability of the operational insurance market.
In all probability the commercial insurance market will rebound from its current difficulties. Some governmental protection will be created. The unraveling will stop. I hope, however, that both the market and its users will take this moment to correct its glaring inadequacies. We need a strong and resilient risk sharing marketplace. We don't have one now.
Copyright H. Felix Kloman and Seawrack Press, Inc.