Untangling the current Professional Indemnity Insurance Market
Many of those involved in the marine services industry, will have experienced the damaging side-effects of the current hard insurance cycle. Professional indemnity insurance is one particular area where the hard market has been most acute, with huge premium increases, reduced cover and, in some cases, insurance being withdrawn entirely. The increase in insurance costs has hit hard and hurt at every level.
Those who have experienced it will know the consequences of the hard market and the widespread difficulties in finding the appropriate insurance cover at a reasonable price. However, the reasons behind the situation may not be fully understood. Vague throw away comments about market cycles, underwriting profits and, most prevalent of all, the aftermath of the 11th September 2001 World Trade Centre attacks, are all routinely utilised by insurance providers as reasons for premium increases and coverage restrictions; however, the true reasons, particularly in the area of professional indemnity insurance, may not be fully appreciated by those seeking such cover.
Of course, insurance markets are, like all financial markets, cyclical by nature and, following the extensive soft market period between 1995 and 2000, when premiums had fallen to extremely low levels, it had been inevitable for some time that the insurance market would harden in due course. However, the severity of the hardening process, particularly in the areas of liability insurance (employer’s liability being the worse hit, followed by professional indemnity) took many by surprise and was caused by a number of contributing factors, beyond the inevitable up-turn of the cycle.
Profitability of insurers
An Office of Fair Trading summary of findings on the UK liability insurance market published in June 2003 (‘the OFT report’) states that liability insurers as a group have been making underwriting losses for the last decade with ratios of 120% - i.e. claims plus expenses exceeded premium income by 20%. This position was clearly unsustainable and appeared to result from insurers routinely ignoring the commercial realities of business, in order to achieve short-term growth over long-term stability and profitability.
The increase in external corporate investors, often American, particularly into the Lloyd’s market, led to a stronger demand to restore profitability and rate on return. However, this drive to return to profitably may have been more gradual had other factors not intervened.
Performance of the Investment Market
During the soft market, insurers had, to a large degree, offset their underwriting losses with investment returns, especially when you consider that, in liability insurances, there is often an extended period between receipt of the premium and the claims payment. The downturn in the investment market after 2000 ended the ability of insurers to underwrite unprofitably, whilst recovering some of these losses in the stock market.
Reinsurance capacity problems
The reinsurance market has hardened significantly in recent years, with major reinsurers of liabilities increasing the cost of cover for direct insurers by between 60% and 80%, whilst also being more selective about the risks they took on and providing less cover. This, in turn, meant that direct insurers had to take on a greater amount of risk themselves. Restrictions in cover, such as in respect of asbestos, also had a widespread affect on the ability of the direct insurance market to provide cover.
Whilst the number of insurer insolvencies in recent years has not been as large as was thought likely at one stage, the collapse of the Independent Insurance Company was nonetheless significant. As a major insurer of employer’s liability insurance, compulsory in the UK, all claims which were not met by this organisation, were subject to recovery under the Financial Services Compensation Scheme (previously the Policyholders Protection Scheme) which, in turn, is funded by contributions from all insurers. The collapse of the Independent consequently led to increased payments by insurers into the scheme, which had to be recovered from policyholders across all classes of business.
The collapse of the Independent Insurance Company undoubtedly also had the further effect of encouraging insurers and their shareholders to accelerate the drive to restore profitability, whilst seeking to eradicate any corresponding practices that had led to the Independent’s demise.
Long-tail nature of liability insurance
Less acute in professional indemnity insurance than with employer’s liability currently in the UK, nonetheless, the long tail nature of liability insurance does create immense difficulties for insurers in trying to predict how claims will develop in the future and, therefore, take them into account when setting the premium. For example, mesothelioma arising from asbestos exposure has an average latency period of 33 years. Consider then how an underwriter setting a premium and terms for an employer’s liability or worker’s compensation policy 33 years ago could possibly have adequately factored in claims arising from asbestos exposure then. It is not possible and, consequently, claim payments have to be recovered from elsewhere, specifically from current policyholders.
Increased insurer regulation
Within the UK, the major overhaul in insurance regulation by the Financial Services Authority (FSA) will undoubtedly lead to greater costs of compliance. In addition, the introduction of a risk-based regulatory approach will, it is predicted, encourage insurers to manage risk more effectively, focus to a greater degree on long-term profitability and commercial sustainability, which should, in turn, lead to steadier pricing and less dramatic swings in the insurance cycle. This approach should discourage a return to the (in hindsight) largely irresponsible underwriting practices which gave rise to the soft market conditions of the second half of the 1990’s.
Reforms to legal systems (Woolf and CFA’s)
Again, within the UK, the introduction of conditional fee arrangements (CFA’s) has led to an increase in the number of claims made (the OFT report suggests rises averaging 78% amongst the top ten liability insurers), whilst many insurers argue that the Woolf reforms, which were designed to speed up settlement of claims in the UK, have merely led to an increase in the costs of getting claims settled. All this is against a backdrop of a legal system in the UK where the Courts continue to ‘generally appear to interpret the law in a manner which entitles people to compensation’ (OFT report), regardless, it seems, of the long-term financial feasibility of such an approach.
Other market forces
As premiums increased, so capacity reduced, because the solvency margin, which regulators require for general insurers under European Directives, is effectively expressed as a percentage of premium. This reduction in capacity has led to a more selective approach, with insurers tending to concentrate on the most profitable existing business. As a consequence of this, competition largely ceases and premiums naturally continue to rise. Only the introduction of new capital can stop this spiral but, to date, liability insurance has remained largely unattractive to potential new entrants, but this will change when premiums reach certain levels of profitability.
Major ‘shock losses’ (WTC, Enron etc)
Whilst undoubtedly overused as an excuse for the hard market, one simply cannot ignore the effect that the World Trade Centre (WTC) losses had on the insurance market. Added to this have been the losses that have accrued to insurers as a result of the financial mis-management of Enron, WorldCom and the Independent Insurance Company and, even more so, losses arising from asbestos liabilities in the US (estimated by actuaries Tillinghast-Towers Perrin to actually exceed the insurance losses of the WTC attacks). Major losses such as these take huge amounts of premium out of the insurance market, which have to be replaced quickly, in order for insurers to be able to continue trading, in accordance with solvency requirements. In the aftermath of the WTC attacks in particular, insurers concentrated on writing short-tail business (e.g. property), where returns can be made more rapidly than in long-tail insurances, such as liability insurance, which further contributed to the acute shortage of capacity in these areas, in the immediate aftermath of this catastrophe.
Whilst these ‘shock losses’ did not cause the hard market, they had the effect of kick-starting, in the most dramatic manner possible, the sudden increase in insurance premiums and loss of capacity. The classic hard market magnified several times resulted.
The OFT report suggests that the ‘bulk of the corrective action will have been taken by Autumn 2004’. This may well be true; however, it is unlikely that the market will begin to drop again in the immediate future for a number of reasons:
1. For reasons already outlined above, the FSA regulatory environment within the UK will make it more difficult for insurers to price risks too competitively, if there is any evidence to suggest that this approach is not sustainable in the long term.
2. The investment markets will need to start performing better and, while there have been some signs of recent improvement in this area, it may be many years, decades even, before rate on return match those that we saw at the end of the 1990’s.
3. Insurers will continue to push premium prices up for as long as they think they can get away with it. That is simply business, and it is a duty they have to their external shareholders, who are far more demanding in this day and age than even 10 years ago. Until market pressures put an end to premium increases, they will continue and, even if they are not as acute as they have been over the last 2 years, it is very difficult to see a period when premiums will begin to fall again significantly in the immediate foreseeable future.
However, there are signs that the worst of the hard market is coming to n end and experienced observers (of the professional liability insurance market, in particular)believe that there will now be a welcome period of relative premium rate stability, commencing towards the end of this year and the beginning of 2004.
Our thanks for this article go to Marcus Elwes FCII of Miller Insurance Services Ltd
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