Risk Management Reports

August, 2003
Volume 30, No. 8
A “Nightmare Scenario?”

A “Nightmare Scenario?”

Early in July, I read a delicious phrase in The Economist. It called luxury goods “ludicrously expensive inessentials.” As I was then preparing my annual review of the insurance industry, it occurred to me that this phrase could apply to a reeling global giant. Is it possible that its skyrocketing premiums and growing financial insecurity will make its products and services no longer essential or even useful?

For the past few years I’ve devoted at least one piece a year to my observations of the insurance world. In 2001 it was “The Unraveling” (December 2001), describing the industry’s tailspin following the events of September 11. In 2002, I continued with “Insurer, Where Art Thou?” (April 2002) and “A Death Spiral?” (June 2002), outlining a mounting skepticism about the ability of property-casualty insurers to regain both profitability and buyer confidence.

This year’s view is even less sanguine. My title is taken from a short report from Aon and Oxford Metrica, prepared by Dr. Deborah Pretty, in which she suggests that the combination of the aftermath of 9/11, the stock market plunge and the need to increase reserves has created a “nightmare scenario of unprecedented proportions for the industry.” I agree. Continuing adverse losses, inadequate underwriting, reserve deficiencies, problems with reinsurance recoveries, an uncertain stock and bond market, an inability to contain operating expenses and a horrible press combine to offset almost entirely the radical, if not irresponsible, rate increases dumped on buyers in the past two years. First during the Nineties the lemmings rushed to undercut prices and offer the moon. Now these same lemmings swing to the opposite extreme, perhaps leaping over the cliff to their mutual destruction! The news isn’t reassuring:

Take expenses as a starter. Despite monumental price increases, the statutory operating expense ratio of US property-casualty insurers, according to A. M. Best (2002), remains at an astronomical 38%, dropping but three points from 41% in 2001. How can an industry survive with this overhead cost, one that leaves only 62% of premiums to pay for losses? This is incredible inefficiency.

According to A. M. Best, the combined ratio (losses and expenses compared to premiums) for US insurers was just under 100% for the first quarter of 2003, the first time since 1986 the industry has produced a profit on underwriting. Yet its statutory return on investment is only 8.8% as compared to the general stock market goal of 15%. With these meager returns and the overhanging threat of massive replenishment of reserves, can the industry attract new capital?

Yet some observers predict that underwriters will relax their prices in light of this newfound marginal profitability. Lower rates could mean more underwriting losses, moving the lemmings ever closer to the precipice.

“The insurance industry is in poor shape, particularly in Europe,” reports The Economist (March 8, 2003). An insurer is more likely than a bank to go under in today’s economy, particularly in Germany, Britain and Switzerland. The reasons: mispriced underwriting, poor investment performance and “messy regulation,” among others. That newspaper’s conclusion: “Insurers today look like the weakest link in the finance-industry chain.” 

Dr. Pretty, in another Oxford Metrica report released on June 30, 2003, cites a continuing exposure to long-tailed liabilities causing the downward trend in financial strength ratings. Clearly this year’s early favorable numbers do not fool the analysts. As she points out, “the creditworthiness of risk bearers” requires the immediate attention of corporate buyers of insurance.

Earlier this year Conning & Co. warned that the “reserve deficiency” of the US market increased from $16 billion in 2001 to $38.5 billion at the end of 2002. Some companies responded: Hartford tripled its asbestos reserves to a total of $5.97 billion; Travelers added $1.3 billion; AIG added $1.8 billion; ACE $2.2 billion and other companies followed suit. But is it enough?

Willis, in its Global Perspectives 2003, called the P/C market an “anemic patient.” 

Look at some of the specific problems that face both buyers and sellers of insurance.

Asbestos: The continuing threat of asbestosis equally affects insurers, reinsurers and insureds. Many corporations have declared bankruptcy to protect themselves  from the avalanche of claims. A RAND Corporation study illustrates the magnitude of this litigation. From 1982 to 2001, claimants ballooned from 21,000 to more than 600,000. Total costs to date are $54 billion but are estimated to soar as high as $145 to $210 billion. Washington finally reacted with a Congressional proposal to establish a national combined trust fund to pay all current and future claimants, a fund that will be financed by corporate and insurance contributions. Trust fund or not, the costs will be horrendous and the effect on the insurance industry enormous. Add to this that we are rapidly exporting to other countries an over-aggressive plaintiffs’ bar.

Wall Street: In the aftermath of the stock-market plunge, investors cry foul, blaming blatant deception by rapacious brokers and analysts. Several major investment firms have settled the initial regulatory lawsuits to the tune of $1.4 billion, some of which will be passed to insurers as claims. In addition these same firms must now settle with their customers, suggesting a spiraling of losses far in excess of the initial payments to regulators. Add these potential D&O losses to insurer reserves! 

Floods: The disastrous floods of 2002 in Europe totaled more than 17 billion Euros, but, of this amount, only 2.8 billion Euros were insured. Insurance thus played a minor role (16%) in these catastrophes. Yet even these insured losses savaged insurer and reinsurer results. Could the insurance industry have handled a 17 billion Euro loss? Probably not. Buyers will now think twice about using conventional insurance as a financing mechanism for catastrophe losses. Governments, including the EU, have stepped in to create funds to deal with similar future disasters. Will conventional insurers expand their underwriting and sales to cover such losses in the future? Probably not. And so the industry becomes even more marginalized. 

Mismanagement: The collapse of HIH in Australia produced a governmental inquiry that has placed ninety directors, managers, auditors and actuaries under scrutiny, according to Asia Insurance Review. This sort of indictment raises serious questions about all management in the industry. 

Sexual Abuse: The outpouring of sexual abuse claims against the Roman Catholic Church in the US (and to a lesser extent in Europe) means more requests to insurers for reimbursement. Worse than that, several Archdioceses have used every means at their disposal to try and deny or reduce claims, even as they argue that they prefer to settle out of court. Why? Their lawyers argue that their insurance policy terms require them to use all possible defense mechanisms before a claim will be accepted. If this allegation is true, buyers will see insurance playing a counter-productive role. To collect any insurance, a claimant must work against its own best interests, and those of the injured parties, just to satisfy a  contractual policy requirement. The attempt to protect future insurance recoveries further destroys the insured’s reputation and the public’s confidence. What value, then, is insurance?

Credit: Another ominous cloud is the potential for insurers and reinsurers to be tagged with bank credit losses. Over the past few years, many insurers and reinsurers bought credit derivatives from banks, ostensibly to improve their investments returns. According to The Economist, these derivatives reached $60 billion by the end of 2002, equivalent to 8% of all commercial and industrial credit portfolios. If the global economy continues to sag, imagine the fresh claims against insurer capital! As The Economist commented “the possible fragility of credit-derivatives markets (has) yet to be fully tested.” It concluded: “savour this moment while it lasts.” 


Service: It was inexcusable to me in 1971, when I first wrote about it, and it continues to be inexcusable. Why can insurance companies deliver a policy of insurance, complete and accurate, along with a premium invoice, in advance of the inception date? It happened to me again this spring. While USAA continues to deliver both policy and bill for my personal insurance before inception, most other insurers are chronically unable to complete this simple task. I ordered a liability policy on May 28, received a binder and invoice on June 17, but, as of July 30, I have no policy in hand! Even worse, I ordered a marine policy in January for a June renewal and received a quote. On the renewal date I called the broker to ask about the cover. He explained that the quote was no longer valid (it lasted only three months!) and that now I needed a boat survey before another quote and coverage would be provided. Am I an exception to good service? I think not, based on similar horror stories I hear all the time 

Governments, nonprofits and corporations don’t sit by idly, watching this drama unfold. They take action, much of which removes significant risk funds from traditional insurance. Increased deductibles and self-insurance are common. Take terrorism insurance, for example. After 9/11, insurers and reinsurers introduced terrorism exclusions. When the US Congress passed legislation (the US Terrorist Risk Insurance Act of 2002) that provided a measure of indemnification for future terrorist losses, underwriters reinstated some coverage, but on an optional basis with an additional premium. Guess what? Buyers aren’t buying! The Hartford reported that 85% of its insureds turned down the coverage and additional premium, and others report a similar disinclination. Most insureds don’t believe that they face a serious exposure, one they think is confined to major cities and infrastructure locations. It is a classic case of adverse selection, something that the underwriters should have foreseen. Take the French as another example. Their insurance risk managers have proposed a new industry-owned stock insurer capitalized at 50 million Euros to underwrite property and business interruption exposures in the 15-25 million Euro range. While this new company hardly solves major capacity and cost problems – it’s too small to do anything but become a minor partner with the ogre they wish to displace – the idea is sound. It could (and should) be beefed up to a capitalization of at least 1 billion Euros should the basic numbers make sense. The Bermuda-based insurers XL and ACE began in a similar fashion in the last high-priced insurance market and it follows a tradition of do-it-yourself that started in the US in the mid-1800s when a group of shipowners, unhappy with the marine insurance rates of Lloyds, created Atlantic Mutual.

A third response example is the use of captive insurers. High prices, limited capacity, and restrictive terms and conditions whet the appetite to do it yourself. Interest and applications are up, according to managers and domicile regulators, but most current and potential owners face the same problems as the insurance managers in France. Their captives are too small to undertake significant loss exposures. They are corporate toys. Couple that with the lack of both fronting insurance (an insurer legally licensed in a needed jurisdiction) and affordable reinsurance, and add the fresh attention of legislatures to squash tax loopholes, and the captive situation is not encouraging. Captive Insurance Company Reports noted in May a “mutual suspicion . . . now exists between providers and captive owners. The fronting provider suspects the security of the captive and its parent; the captive owner suspects the security of the fronting company!” Although single-parent captives may do little to defuse the cost-coverage situation, group-owned insurers could provide some relief and set the stage for a mass exodus of funding from the traditional market.

And finally, there is the example set by Warren Buffett. According to The Economist, when faced with seemingly irrational rate escalations in Directors’ and Officers’ Liability insurance, he decided not to buy protection for the board of Berkshire Hathaway, a company that includes several insurers in its stable. His idea: scrap the by-laws that indemnify directors and let them buy their own coverage. That may reduce the pool of available directors but it will produce more responsible ones! This could be the beginning of a change in buying habits that materially affects the market.

Now consider the bad press received by the insurance industry. I think much is selfinflicted. A knee-jerk reaction of cancellations, exclusions and price increases in the US followed 9/11, much of it without communication with policyholders. Asian insurers gave us a similar knee-jerk reaction of after SARS hit. According to Asia Insurance Review, many said they would not cover SARS-related claims. Some Australian travel insurance companies specifically deleted coverage. Then the more aggressive firms turned around and offered special policies, those that provide $50,000 for both SARS and terrorist attacks! Exclude the exposure and then offer a special, new, high-priced policy to cover it! That does not enhance the reputation of an industry that purports to be there when you need it. Did anyone consider how potential buyers react to these stories? The same issue reported the CEO of a major Japanese insurer stating that “Insurers can meet the needs of society by providing medical and healthcare insurance, contributing to the prevention of accidents, maintaining a high standard of morals for good corporate governance, and even providing covers against catastrophic risks such as flood and terrorism.” When buyers contrast platitudes such as this with the continuing headlines of mismanagement, cancellations, exclusions, and financial insecurity, they begin to wonder.

It was no different in Ireland where a spate of recent cancellations and price increases reached news reporters, making insurance a “hot topic,” according to a New York Times analysis. It resulted in a national effort to create a Personal Injuries Assessment Board to weigh injury claims and award formula-based compensation. This proposed Board effectively removes claims management from insurers! The Irish don’t trust insurers to settle their own claims.

Medical doctors in three US states symbolically “walked out” this year in protest against increasing medical malpractice insurance premiums, provoking front page headlines all over the US and a move in Congress to limit awards. Regardless of the merits of the case involving physicians, claimants and plaintiffs lawyers, the news reports have uniformly cast a negative cloud over insurance companies. They are accused of investment mismanagement, draconian premium increases, and sloppy defense, allegations, whether true or not, repeated in many news stories. One major underwriter, the St. Paul Companies, exited the market and others plan to do the same. It is the same story: the insurance industry sits by while cast in the role of perpetual villain.

Not only the national press is dangerous. Local editorials do even more damage. “Insurance companies, it seems, are increasingly risk-averse these days,” said the editor of Working Waterfront in June 2003. The accompanying article reported that many owners of properties on islands could no longer get any insurance, even at escalated premiums, allegedly because of their remote locations. Even though most islands have volunteer fire departments as efficient as those on the mainland (a frame dwelling is likely to burn to the ground in either location!), it seems to islanders (and to others) that insurance underwriters are seeking any excuse not to write insurance. This is the message that comes across in these local papers.

So what is the state of the insurance union this summer of 2003? It is infirm but the disease is not terminal. Have I selected some of the more egregious negative examples? I plead guilty. I admit that I’ve taken those examples that illustrate a central theme of an industry, especially in the US, that is mistrusted for its underwriting, its claims-payment practices, its operational efficiency and its financial security, by experts and the laity alike. Is this, however, a “nightmare scenario” in which traditional insurance becomes “inessential,” to be replaced by other means of risk financing? I am not as pessimistic as I may sound. I believe that the global property and casualty insurance business has sufficient inherent strength to overcome these current difficulties. The reason that I’ve been a continuing critic of its deficiencies is that I maintain an underlying belief that it can, and will, resurrect itself, with fresh leadership. Insurance remains an important part of the global financial community but it must recognize that it is only one of a number of possible solutions to loss financing. It requires radical surgery to change its basic operating procedures. It requires consolidation. It requires more intelligent regulation, global, national and local. And it requires a fresh approach to service to its customers. Only then can it reestablish public confidence in its products and services.

A nightmare is but a dream from which we awake, thankful that it is not reality.

At the most we gaze at it in wonder, a kind of wonder which in itself is a form of dawning horror, for somehow we know by instinct that outsize buildings cast the shadow of their own destruction before them, and are designed from the first with an eye to their later existence as ruins.

W. G. Sebald, Austerlitz, Modern Library, New York 2001

Copyright 2003, by H. Felix Kloman and Seawrack Press, Inc.

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