The recent Mactavish report had some severe criticisms for the commercial insurance sector. Sam Barrett reports on the warnings it contained.
When research company Mactavish published its findings on risk within the commercial insurance sector earlier this year, few escaped criticism. The report warned that, without a significant overhaul to address changes flowing from the recession, a "perfect storm" was brewing for both insurers and risk managers — and predicted an insurance crisis could prove to be the final chapter of the credit crunch.
Not only did it draw parallels between today's large property and casualty insurers and the "more publicised past failures of financial institutions", but it warned a "severe insurance market correction" will follow the "systemic under-pricing of risk" and alerted investors to the fact they could end up bearing the brunt of losses.
"It's a simple story," says Bruce Hepburn, chief executive officer at Mactavish. "As a result of the credit crunch and the recession, businesses are facing the toughest trading situation in a generation. They're having to make strategic changes to their operating models, which means their risk profiles change and, therefore, so should their insurance requirements. Individually it's unremarkable but collectively it's very significant."
Examples of these changes include: businesses moving into less familiar activities to generate additional revenue; cutting costs — for example, closing distribution centres or reducing headcount; and reducing lead times on product development. Clearly these types of changes can hold implications for a company's risk profile. If a company closed three of its four distribution centres, for example, a fire or flood in the one remaining centre would have much more serious implications for both it and its business interruption insurer than if it was still running all four.
"The pace of change is unparalleled," adds Mr Hepburn. "But while it's positive that UK businesses are responding to the market conditions by being more entrepreneurial, very few are focusing on the new risks or considering whether they need to disclose this to their insurers." Consequently, he predicts insurers will face surprises when claims start to come through, with insureds receiving even bigger surprises as they discover they're not covered. "It could take up to five years for this to filter through," he says. "Claims on product liability, BI and professional indemnity are high severity but low frequency, so it will take time to happen."
Not only will this potentially have ramifications for insurers but also for insureds. On the one hand, if an insurer agrees to pay a claim, this will cost both it and its shareholders while, on the other, if the claim is declined, the insured business could find itself in financial difficulties.
Focus of concern
The risk of this mismatch in cover is a significant concern for the Association of Insurance and Risk Managers and its members. John Hurrell, Airmic chief executive, explains: "The main focus of our concern is the extent to which these changes aren't being disclosed. Under the Marine Insurance Act 1906, non-disclosure of a material fact can allow the insurer to avoid the contract completely. The punishment doesn't really fit the crime."
To show just how easy it is for a company to potentially fall foul of this, he says that a larger corporate buyer with operations in many countries might spend six months preparing an underwriting submission, only to find that, on the day it is submitted, it is out of date. "The law is very much in the insurer's favour. It needs to be updated to take into account today's business environment — multinationals didn't exist in 1906," he adds. "It's not right that an insured doesn't have certainty when it takes out insurance."
In addition to surprises for both insurers and their corporate clients, a knock-on effect could be an increase in legal action. Alexander Oddy, partner in the insurance disputes group at Herbert Smith, draws parallels with 1998 to 2000, when the market was last soft and anticipating a correction. "When the market corrects itself, the expectation of those in insurance companies is informed by the harder market, even though the business was written in a soft market. This leads to disputes," he says, adding that he spent many years working on cases that arose from risks written between 1998 and 2000.
This time round, the situation will be exacerbated by the economic climate, as Mr Hepburn explains: "It's very different to the last hard market. Then customers had access to credit and could borrow while they waited for an insurance payment. This has made insurance a much more important business tool."
Insurers and brokers both come in for criticism for failing to respond to these changes, with the report's suggestion that systemic under-pricing of risk will result in a severe market correction. As well as highlighting this, the research recommends that insurers need to develop new ways of writing insurance, taking into account the change in risk but also looking at how risk is assessed.
"Insurers have made money from their investment returns but the underwriting results haven't been compelling," says Achim Bauer, an insurance partner at Pricewaterhouse Coopers, which reviewed the research. "The only way they can outperform is to move to better practice when it comes to underwriting."
Mr Bauer would like to see less reliance on historic trends in underwriting, with insurers also taking into account the dynamic development of risk going forward. "Some insurers are already developing these methodologies," he concedes, "but the industry is very slow to adapt and it's far from a joined-up approach. At the moment, as long as there's enough innocent capacity, risk just goes somewhere else."
While the availability of capacity means there is always room for a risk, Mr Hurrell believes little incentive exists for insurers to improve the situation while they have a get out clause in the shape of the Marine Insurance Act 1906. "The business environment moves fast and there are areas, such as cyber risk, where underwriters aren't up to speed. But there isn't really any motivation to change this if they know they have the right, under the legislation, not to pay," he explains.
To address this, Mr Hurrell would like to see more transparency in the insurance contract. "We want greater clarity on both sides," he explains. "If we could thrash out an 'in principle' agreement with the insurers — very much like a pre-nuptial agreement — that would give our members more certainty about what cover is in place."
A further danger for the insurers, if they continue to under-price risk, is that their reserves will erode if they don't respond quickly enough. The report suggests this risk is heightened by the fact competition has forced insurers to operate on tight margins coupled with an unusually benign claims environment. "Brokers and customers need to give more attention to the financial health of insurers in this cycle," says Mr Hepburn.
He also believes there needs to be a change in the way insurance is placed, with brokers focusing more on the liability of the policy rather than the price, so there isn't a mismatch between risk and cover. "The industry has reached a point where it needs to look more carefully at how business is placed. We're reviewing broker submissions for a report we're publishing later this year and that indicates that placing standards are plummeting," he explains. "It needs a major overhaul."
But while the Mactavish report is hard-hitting in its criticisms, its targets are quick to defend themselves. "The report makes some good points but to draw the conclusion that we're not thinking about what's happening in the market isn't right," says Chris Hanks, general manager of Allianz Commercial. "There have been mistakes and, as a result, there will be some shocks, but it's not as dark as the report suggests."
For starters, he says, not all the changes that are occurring to businesses' operating models serve to increase risk. By way of an example, many firms are keeping less stock, which reduces the potential loss. Likewise, with more empty business properties available as a result of the recession, it can be much easier to find alternative premises in the event of fire or flood. This can significantly reduce the cost of a business interruption claim.
On top of this, as far as the disclosure of material facts goes, Mr Hanks believes insurers have responded to the tougher climate by doing more to ensure customers do not get caught out. "We're conducting more surveys as a result of the economic climate. If we visit a business it becomes our responsibility to notice things," he explains.
Likewise, at XL Insurance, there is recognition that corporate clients are undergoing a faster pace of change and that this needs to be factored into their insurance. "We do work hard to get a handle on risk exposures," says Nigel Bamber, head of client relationship management at XL Insurance. "It's not possible to get it 100% accurate — as you're using hindsight for a future period — but we try to get as close to the customer as possible to understand the issues. On top of this, we have property and casualty risk engineers that perform part of our risk evaluation process."
These claims about a collaborative approach do find some support among corporate risk managers. Chris McGloin, vice president of risk management and insurance at Invensys, says he works closely with both his insurers and brokers to ensure his company isn't exposed to unacceptable levels of risk. "Companies are in business to take risk but it has got to be considered risk. We work with our insurers to understand our exposures and how we can mitigate them," he explains. "The report is a good reminder that we need to do this but I don't think there needs to be a dramatic change — large companies are doing this already."
Taking such a partnership approach makes sense on a number of levels. By working together, the company can take the necessary steps to reduce risk wherever appropriate, and the insurance can be tailored to pick up the bill if the unexpected does occur. This use of risk management practices should filter through into the premium, with those companies embracing good practices feeling the benefit in lower insurance costs.
Mr McGloin adds that he would always ensure the finer detail of cover is fully understood and that any changes in the business operating model are passed on to the insurer. "It has to be informed risk taking, both for us and for our insurers. We can't expect them to pay out blindly," he adds.
Working with insurers
An example of how companies are working with insurers is provided by Gary Marshall, corporate risk manager at Polestar. He says that, earlier this year, the business had to modify some of its operating processes as a result of the severe weather. "We'd run some of our processes outside but the weather meant we had to move them indoors. This changed the nature of the risk so we assessed it and informed the insurer, which was happy with the steps we'd taken," he explains. "This dialogue with the insurer is important as it ensures each party comes to a position that is acceptable."
Another criticism levelled at insurers which they seek to rebut, is that their financial health is below par. They argue that regulation ensures they remain in rude health financially. "The regulators make sure we have enough capital in place and Solvency II will make us focus even more on enterprise risk," says Mr Bamber. Additionally, both XL Insurance and Allianz report that they have increased their reserves in the last year. "This makes the insurance crisis described in the report much less likely," adds Mr Bamber.
Yet while there are points in the report that insurers and corporate risk managers disagree with, there are also areas of consensus. In particular, everyone agrees that risk has been under-priced to some extent. Mr Hanks says: "I partially agree with Mactavish regarding the systemic under-pricing of risk. This is cyclical and there'll always be risks that insurers never get right. Just as long as overall the book makes money it's not a problem."
And there are signs that prices are inching upwards. According to Mr Hanks this has mainly been at the smaller end of the market but is likely to develop further over the course of the year. This gradual correction will, it is hoped, prevent a more severe correction in the long term for buyers.
Is the report too critical?
How much of an overhaul is needed in commercial lines?
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