I first heard about “risk management” shortly after I joined an insurance brokerage firm in 1957. For the next thirteen years I studied both the insurance business and the growing risk management discipline, before deciding, in 1970, to devote all my time to risk management consulting. Insurance remains part of my core training and a continuing interest.
I had occasion to reflect on its past, present and future several weeks ago at the 45th reunion of my college class, where I talked with classmates who had spent their careers in property/casualty insurance and reinsurance. We shared our concerns about its future, given the industry’s current problems with credibility, competition, and finances. These ruminations result from those discussions and some recent reading.
First, credibility. How is it that an industry predicated on underwriting risk has been chronically unable to produce a profit from that effort for more than twenty years? Its profits and surplus increases are the result of investment income and appreciation. Each year the industry reports combined ratios (losses and expenses compared to premiums) over 100%. Year after year, companies raid their loss reserves to bolster reported profitability, bringing closer the day of reckoning. Myron Picoult, of Wasserstein Perella, a long-time critic of the industry’s financial games, wrote late last year, “ . . the industry has been severely undermining the integrity of its balance sheet by cheating on reserve levels. . . . The industry’s weakness (is) being too monochromatic on its revenue stream, relying too long on net investment income as its savior, missing the boat on the need to retain seasoned underwriters, and being dazzled by its excess capital position—both real and apparent.”
Has a shake-out started? Within the last six months, CGU and Norwich Union, recently merged, spun off their property/casualty business. Reliance National dumped its CEO and looks shaky. CNA reported a $363 million after-tax reserve charge. The Frontier Group added $136 million to reserves, cut staff, and restructured. Lack of financial credibility is only one problem. Policyholders continue to flunk the industry on service quality. Insurance policies are seldom delivered on time and are invariably full of errors. One financial officer recently noted that his broker spends one-third of his time just correcting policy mistakes.
Andrew Berry, who heads the Global Risk Exchange, in Providence, RI, summarized these deficiencies in the April issue of Risk Management . The industry’s product is inefficient—it carries an expense load of almost 30%. It does not understand its customers, in part a result of the unnecessary insulation from them by the outmoded agency-brokerage system. Its customers are unsatisfied, and they seek alternatives in risk financing. Recent changes in the law in the US (the demise of Glass-Steagall), the emergence of strong capital markets, and the explosion of new technologies in e-commerce lead to converging ownership of risk financing organizations, new financing products and a new emphasis on the risk management discipline itself.
There is some good news. Some leaders in the business actively try new initiatives. The recent melding of weather and conventional property and liability risks for United Grain Growers in Manitoba, Canada, by Swiss Re New Markets is an attempt to respond to an organization’s major risks in a more integrated fashion. It proves that imagination and innovation are not completely missing in insurance.
Second, competition. Why are so many organizations moving to new forms of risk financing? One reason is the labored limitation of the property/casualty insurance business to risks of marginal significance to balance sheets and earnings statements. Most conventional insurance addresses risks of minor corporate consequence. United Grain Growers, for example, determined that its six major risks are: (1) grain volume/weather, (2) environmental, (3) credit, (4) commodity price and basis risk, (5) counterparty exposure, and (6) inventory risk (See CFO Magazine, June 2000). Most of these never appear in insurance offerings. Then consider the industry’s propensity to add exclusions the minute a new risk emerges (environmental and employment practices are illustrations), and the marginal utility of conventional insurance is further reduced. Finally, do the amounts of coverage meet
corporate needs? Where the industry offers limits of $100 million to $400 million, major customers need $1 to $4 billion. Even to obtain those lower limits, a buyer must cobble together twenty to thirty insurers and reinsurers, substantially increasing administrative time, cost and counterparty risk. All of these deficiencies open the door to competition.
That point about exclusions was illustrated in June, on the arrival from England of a friend who sailed his 48’ sloop across the Atlantic. He had prudently arranged for marine insurance from a Lloyd’s syndicate to cover his trans-Atlantic cruise and his travels along the New England coast prior to a winter lay-up in Thomaston, Maine. Yet the underwriter had carefully excluded any protection against loss or damage arising out of a hurricane! Given his itinerary in New England and his wintering ashore in Maine, I found it ludicrous that the underwriter could cover the ocean voyage, but not the risk of hurricane. It’s another example of failing to meet the needs of the customer.
I have suspected for some time that the albatross hanging around the neck of the property-casualty industry is its old-fashioned insistence on the “Indemnity” principle. One of the first maxims taught me back in the 1950s was that insurance is intended to restore the policyholder to the financial position immediately prior to a loss. Failure to adhere to this approach raises the ominous specter of moral hazard, the possibility that a policyholder might actually make a profit from an insurance recovery. Since insurance companies act as fiduciaries holding the contributions of the many for the benefit of the few that sustain losses, this idea seemed perfectly fair.
Yet does this principle of indemnity make sense today for organizations? Following a loss event, many require additional funds not just to restore a physical position ex poste ante, but also, more importantly, to rebuild reputation and the confidence of customers and suppliers. They also may want to take advantage of the situation to improve their competitive and market position. Insurance, limited by the indemnity principle, offers little financial support for these broader objectives.
Consider an example: a manufacturing company sustains a fire in one of its factories, a critical assembly point for a fast-selling product. It implements its contingency plan, shifting assembly to other facilities and contractors within 24 hours. It notifies its customers and suppliers, and spends considerable funds to accelerate rebuilding and to assure that its customers receive their full orders or financial reimbursement. The result: the customers react favorably to this quick response and increase their orders, giving a spurt to profits in the next twelve months. But insurance covers only an actual “loss of profits,” of which there was none, and the extra expenses to restore the old level of income. So insurance is of minimal importance in this situation. And it probably will take more than eight months to get any insurance recovery whatsoever! Isn’t it natural that an organization will look to other financing (banking, for example) as being more responsive to real needs?
Another example: regulators advise a company of a product flaw and demand a recall. It immediately initiates the recall, notifies its customers, changes its manufacturing systems, and takes out extensive advertising to advise the public. The cost is high, but its reputation is restored, even improved. At the end of the year its profits are up, not down. The expenses far exceeded what insurance covers. Was there even a “loss” in insurance terms?
All of this suggests that we need a new contractual relationship between an organization and its risk financiers, one of sharing costs rather than one of indemnifying losses. The convergence of banking, capital markets and insurance will produce more innovative funding for contingency events. These arrangements will not be limited to restoring the status quo but will permit the partners to create opportunity. The property/casualty insurance industry, in new linkages with its sister financial institutions, can begin to restore its credibility and play an important role in meeting today’s major risks.
Can insurers earn a reasonable return on underwriting the significant risks, using the new concept of “sharing” rather than “transfer,” and eliminating the insistence on the indemnity principle? I think it possible. By the time of my next reunion, our 50th, in 2005, I’ll report on progress.
Copyright H. Felix Kloman and Seawrack Press, Inc.
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