The Global Challenge for Insurance

148 The Global Challenge for Insurance NFT 2/2003 The Global Challenge for Insurance by Jens Erik Christensen Jens Erik Christensen jens-erik.christensen@emea.royalsun.com Jens Erik Christensen is CEO of Codan A/S and Managing Director of Europe, Middle East & Africa (EMEA), Royal & Sun Alliance (RSA). There are a number of themes or challenges such as The global crisis in long-tail liability insurance, US asbestos liabilities, Whiplash claims, Compensation culture, Insurance pricing and they are all centered around core disciplines inherent in the insurance business.Unfortunately we have as an industry had a sort of inferiority complex with the banks, not least in terms of the question of distribution power, and we have been struggling so much with heavy costs that we have forgotten the basic focus and discipline to any business In the last few years it has been evident that the value creation in insurance – general as well as life – has been inferior to other financial sectors and the markets in general, with the TMT sector being the only one having a worse performance. This has happened despite the hardest mar- ket in general insurance for both insurers and reinsurers in years. The reason for the poor performance is underreserving for long-tail liabilities such as asbestos and D&O, but foremost the global downturn in investment returns. Within three years, the insurance in- dustry has gone from being overcapitalised to being undercapitalised or thinly capitalised. For a long time the insurance industry has relied on investment income to make up for underwriting losses in general insurance, and in life insurance heavy exposure in equities has proved to be a strong mismatch with the guaranteed benefits to the policyholders. Solvency issues are high on the agenda as are questions about risk management and management of the assets and liabilities. Many companies are trying to raise capital through rights issue, cutting of dividends, and in life insurance reducing payouts to policyholders, and shedding assets, i.e. selling operations not core to the business. The real challenge is of course to make the insurance operation profitable and in a sustainable way. In ge- 149 The Global Challenge for Insurance neral insurance the combined ratio (claims + expenses divided by premiums) should be brought below or well below 100% through substantial rate increases and changes in terms and conditions. In life insurance there is a strong need of innovation and of sharing the investment risk between companies and policyholders. Just to introduce the concept of „true“ profitability in the life insurance in- dustry will be a first revolutionary step. The insurance industry is a major industry as part of the overall financial system. The global insurance industry had premium reve- nue in 2001 of USD 1,439bn from life insur- ance and USD 969bn from general insurance and financial assets about USD 12,500bn (Sigma, Swiss Re, June 2002). If a major insurance company – life or general or rein- surance – would go bankrupt, it would no doubt be a shock to the financial system and could have a domino effect. There are a number of themes or challenges that dominate the insurance industry, and I shall try to give my view on them as far as general insurance is concerned. The global crisis in long-tail liability insurance The fundamental nature of insurance is risk transfer from the policyholders to the insurer and the ability and capability of the insurer to manage risk in a predictable and controllable way. Technically speaking, by pooling (ho- mogeneous) risks it is possible „collectively“ to diversify a considerable part of the „indi- vidual“ risk and the residual non-diversifiable risk can be managed in a reasonably predict- able way. This is, if you like, the theory based on the law of large numbers etc., but in real life things are not that easy. The main reason for this is the long-term nature of many lines of business, in particular the liability lines of business with a long and uncertain claims settlement process. The main challenge with long-tail line of business is to recognize and quantify the super- imposed inflation, i.e. inflation over and above CPI or wage-index related inflation. We see for almost all general insurers sub- stiantial reserve upgrades. For those compa- nies that have actually gone bankrupt this can almost always be attributed to massive under- reserving and significant underpricing with high and unsustainable growth. Despite mas- sive underreserving it is possible for those insurance companies to have positive cash flow for many years before running out of cash abruptly leading to collapse. There are endless debates on the proper recognition of the long-tail line of business in financial reporting (IAS) ranging from con- cepts of fair value to prudency and from discounting of liabilities to augmenting re- serves with market value margins. Whatever the outcome there is no doubt a need for a sort of revolution in how to assess and report long- tail liability risks. It is in this context strange how little attention analysts pay to the ques- tion of reserve adequacy, at least they seldom perform any thorough analysis of this issue. In fairness this may be ascribed to the scarcity of information on run-off performance given by the insurance industry. To me it seems obvious that the manage- ment of the companies that have gone bank- rupt in recent years due to massive underre- serving did not have any idea of the nature of the insurance business and in many instances the local regulatory body neither. The bank- ruptcies in the insurance industry are not of the Enron or Worldcom type failures best described as corporate malfeasance. Unfortu- nately, the discussion on corporate govern- ance is very much based on these cases and not what would be more important for the insur- ance industry to prevent future collapses: better means of assessing and reporting long-tail liability risks. 150 The Global Challenge for Insurance US asbestos liabilities Asbestos is perhaps the most extreme exam- ple of long-tail risks. Asbestos litigation has cost US business some USD 275bn and gen- erates about 50,000 claims a year (American Insurance Association). To understand asbes- tos you not only have to have a good under- standing of actuarial methods, but also of many behavioural issues such as how age affects the willingness to sue over asbestos and peculiarly the new asbestos risks that emerged in 2002 such as non-product expo- sures. We have already seen lawsuits where non-impaired claims – where plaintifs are lacking symptoms of asbestos-related ailments – are getting sizable settlements. Whiplash claims There is an ever increasing incidence of whip- lash claims. In the UK about 80% of all motor personal injury claims relate to whiplash con- ditions. There is also a growth in claims based on post-traumatic stress disorder. Whiplash injuries now affect 1 in 200 people every year with 250,000 claims per year [source: ABI]. Whiplash is an injury that can neither be seen nor revealed by x-ray, and hence it is difficult to dispute or disprove the injured’s version of events leading to the injury or of the recovery time needed. Medical experts also readily take the injured’s accounts at face value. Fraud and exaggeration is consequent- ly endemic to whiplash claims. Compensation culture There are two concepts that are key in insur- ance, and they are often confused, namely mutuality and solidarity. Mutuality is the prin- ciple of private, commercial insurance, where- by individuals enter the insurance pool for sharing losses and pay premiums according to the best estimate of the risk of the individual (this applies to all insurers whether organised as a plc or a mutual company). Solidarity is the sharing of losses in a similar fashion, but with payment according to some scheme, e.g. tax. It is essential that the scheme is compulsive and comprehensive. State social insurance is a good example of solidarity. Only mutuality involves assessment of risk. In order for mutuality to work it is extremely important that it is based on the principle of utmost good faith, i.e. each side declares all it knows about the risk. However, we see a huge spread of a com- pensation culture which very much violates this principle. This disease started in the US and has spread to UK and increasingly to other countries in Europe. Compensation culture is often referred to as ‚blame and claim‘ and refers to the willingness of individuals to take legal action against whoever they think is resonsible for injury or damage. In the US the compensation culture actually is a threat to US business’ ability to compete. Examples of ridiculous damage awards are: an 81-year old won $ 3m damages against McDonalds after spilling hot coffee on her lap, a shoplifter being arrested was awarded $3.2m against Wal-Mart for the trauma of being handcuffed in front of her children. The legal system in the US does support this compensation culture as it is rare for the losing side to pay the other side’s legal fees (there- fore no incentive for defendants to avoid liti- gation). Moreover, damages are decided by a jury (and not a judge), and often punitive damages are being awarded. Unfortunately, in Europe we see the introduction of no win, no fee arrangements making it easier to sue than ever before. To add insult to injury the final bill for this compensation culture typically ends up with the insurer. 151 The Global Challenge for Insurance Historically, hard markets have been short lived and have not always led to sustained underwriting profits Net written premium % change / Incurred loss % change 1960–2000 Source: McKinsey Underwriting cycles More or less irregular cycles of underwriting results are apparently a structural characteris- tic of the general insurance business. Cycles can vary significantly between countries, markets and lines of business although very often being masked by smoothing of pub- lished results. Among the causes behind these cycles are factors like • time lag effect of price changes trends, cycles and short-term variations of claims (and claims inflation) fluctuations in interest rate and market val- ue of assets and not least the interaction of each of these factors. Above is shown for the American market an example of these cycles. The interesting feature is that the hard mar- kets have a much shorter duration than the soft markets. Why are the insurers not interested in making decent profit or rather only make decent profits for short periods followed by longer periods of mediocre results? Probably because the insurance industry has attracted too much (cheap) capital, hence being over- capitalized leading to overcapacity and silly premium levels. Fortunately it seems as if we p.t. are entering a period where there is less overcapitalization and in many instances short- age of capital. Basically, underwriting cycles – life profit fluctuations in other industries – reflect com- petition, i.e. the interdependence of rival firms. Customer loyalty and demand inelasticity (at country or market level) ensure comfortable returns for incumbent firms, but on the other hand the apparent ease of entry into insurance, the lack of market concentration (in most markets) and the difficulty of monitoring the prices of competitors make it impossible to make excessive profits. This keeps the market in disequilibrium with ongoing price fluctua- tions. How to beat the underwriting cycle and achieve decent returns on capital through the cycle? And given the market conditions, is it at all feasible? That is of course a major challenge for any insurance company. -10% -5% 0% 5% 10% 15% 196 1 1963 19 65 196 7 1969 19 71 197 3 1975 197 7 197 9 1981 198 3 1985 19 87 198 9 1991 19 93 199 5 1997 199 9 152 The Global Challenge for Insurance Progressive GEICO (D) AIG Auto-Owners Cincinnaty Financial Safeco Chubb Ohio Casualty Allmerica P&C USAA (D) 20th Century (D) American Financial American Family Sentry St. Paul State Farm (D) Auto Club of So Ca (D) General Accident Reliance Amica Mutual (D) Allstate (D) Farmers (D) Nationwide (D) Kemper National Hartford USF&G Travelers Commercial Union CIGNA CNA Prudential (D) Liberty Mutual (D) Lincoln National -15 -10 -5 51015 Better than median Worse than median Percentage points worse than industry median Percentage points better than industry median Leading P&C companies have managed to sustain a combined ratio advantage over time Note: Median for industry over 5-year period 1979–1983, 1984–1988, 1989–1993, 1994–1998; (D)=Direct writer Source: McKinsey analysis Percent, 1979–1998 Insurance pricing Below is shown for the US market how it is possible to sustain a better profitability across the underwriting cycle. These are indeed very impressive facts and encouraging news for well-run insurance com- panies. What is not shown on this graph is that the better performance has not been achieved at the expense of growth. A key issue for the better performers has no doubt been a strict underwriting discipline, but I would like to point out for personal lines business as well as SME in commercial insur- ance there is much to be achieved by better pricing through a much more sophisticated approach than is typically the case. Many insurers manage profitability on a total portfolio rather than on a segment-by- segment basis. A sophisticated company has huge scope to beat the competitors consist- ently by correctly assessing the risks and leveraging the customers’ price sensitivity (elasticity). Sophisticated insurers use 40-50 variables to price a simple auto or homeowner’s policy. Continuous pricing pilots give these insurers the ability to check the behaviour of consum- ers and to trade off profit margin against volume. 153 The Global Challenge for Insurance Sophisticated insurers also monitor closely the development of the real rate of interest (based on the true underlying claims infla- tion) to make sure that the technical price (as set by actuaries) is adequate. Running a successful insurance company depends more on the effectiveness in your pricing (or underwriting) than on efficiency in your various administrative processes and your acquisition costs. Risk based capital Improved capital management – or just start to try to manage your capital – is a key challenge for general as well as life insurers. In the past assets and liabilities have been managed in strict separation and by different functions within companies. ALM (Asset- Liability Management) techniques are now if not commonplace then not a completely alien concept in life insurance. There has recently been much focus on the volatility of having equities in your invest- ment portfolio. A little piece of warning: bond risk is asymmetrical – you could go bust, but no one is ever likely to double in price, as a share could! In general insurance concepts of risk based capital have been introduced in many insur- ance companies. Risk based capital is the amount of capital that should be held to coun- terbalance the risks being assumed by the insurance company. To quantify the RBC there needs to be an assessment of the inherent statistical variability of the financial return. Expected losses can be allowed for in the pricing of the product, but additional capital is needed to cover unexpected losses. One way of defining RBC could be as the capital need- ed to make sure with 99% probability that the Capital to NPW ratio will not fall below, say, 25% within a five-year period. The real value in the TBC concept is of course when applied to a particular line of business or customer segment and to make it an integral part of the pricing of that line or segment based on the required return on RBC (over and above the cost of this capital). RBC concepts apply of course to life insur- ance as well. RBC systems have taken the best part of a decade to catch on in the banking sector. Banks have for a long time attributed capital to individual lines of business and have been monitoring performance at these levels (risk in bank = risk of default on loans). One important technique to work with in general insurance is DFA modelling (DFA = dynamic financial analysis). A DFA model is a stochastic model of the main financial fac- tors of an insurance company, comprising such risks as pricing/underwriting of risks (risk of in- adequate premiums) reserving risk (risk of insufficient reserves) investment risks catastrophes (e.g. windstorms) A good DFA model makes it possible i.a. to assess the impact of varying reinsurance strat- egies/coverages to the financial result and stability of an insurance and hence an impor- tant tool in the overall risk management of an insurance company. Risk Management Insurers probably trail at least 10 years behind banks when it comes to risk management systems and practices. Even though the main drivers of risks with general insurance are liabilities and various insurance events (catastrophes) and assets are the main drivers of risk in banks (and life insurance), the same principles of risk man- agement should apply. At the heart of risk management is of course governance. A model commonly found in banks is based on three lines of defense: 154 The Global Challenge for Insurance 1st line the business unit & divisions where risk identification, measurement and control are actually carried out 2nd line a risk function, advising on stand- ards and challenging the business on risk matters 3rd line an independent internal audit func- tion. In most insurance companies the second line of defense, an independent risk function, is often missing or poorly defined. To establish proper risk management is also key to im- prove the financial performance as it ensures – not least in underwriting – a necessary, strict discipline. Concluding remarks I have just touched upon a few challenges that I believe are facing the insurance industry (particularly the general insurers) worldwide. Much is centered around core disciplines in- herent in the insurance business. Unfortunate- ly we have as an industry had a sort of inferi- ority complex with the banks, not least in terms of the question of distribution power, and we have been struggling so much with heavy costs that we have forgotten the basic focus and discipline needed to run any busi- ness. High level strategic thinking, particular- ly in distribution, and strategic consolidation issues have distracted a lot of insurance busi- ness from the (boring) operational issues on execution. As a profession we need to reestablish a proudness about our work and our important contribution to society and make sure we do that job in a professional manner and thereby live up to our social responsibility in society which is mainly to make sure we run profita- ble businesses! – Insurance is actually a won- derful business embracing very many aspects of our societies.