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The Actuary The magazine of the Institute & Faculty of Actuaries
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Non-life: Road to recovery

In looking at the effects of recession on the non-life sector, we have not concentrated on the increase in claims, which is likely to be greatest in classes such as trade credit, payment protection, mortgage indemnity, D&O and E&O, or the downturn in premium volumes, which is likely to be greatest in classes such as construction, marine construction and cargo workers’ compensation, but instead on some of the broader possible effects.

Medium-term economic effects
Whatever the short-term path for interest rates and inflation as governments attempt to use fiscal and monetary policies to avoid a profound slump, there are likely to be medium-term impacts on economic variables. Fundamentally, the crisis stemmed from a high level of Western consumers’ and companies’ indebtedness. To reverse this will require a period of one or all of the following: high inflation rates, high debt defaults or low consumption and hence, low economic growth.

After a long period, until around two years ago, of low and stable inflation, non-life insurers are rediscovering the skills needed to navigate through a world of unpredictable inflation, with its resulting effect on an industry which takes premiums upfront in exchange for guaranteeing against uncertain future payouts.

Many commentators are predicting that the economic crisis will cause a long-term fall in the power of the West and, particularly, the Anglo-Saxon economic model, and a transfer of economic power to China or the Middle East. What will this mean for the non-life industry, which has traditionally been dominated by the West? Will we see Sino and Sovereign Wealth Fund investment in the insurance industry? Or have the losses they have suffered in Fortis and the UK and US banking sectors dented their appetite for Western financial services?

Foreign exchange rates are also likely to continue their volatility as the global economy attempts to readjust to a new equilibrium — for instance, the rise of the Renminbi as a reserve currency at the expense of the dollar.

For many non-life insurers, classic foreign exchange mismatch risk — between assets and liabilities — is less of an issue as claims reserves are commonly closely matched to the underlying liabilities. However, many insurers writing business globally, for example, at Lloyd’s, have already found themselves with a mismatch between capital commonly held in local currency for the head office and capital drivers, principally based on potential claims liabilities and premium levels; and expense levels based on the currency of domicile of staff and premium levels.

Counterparty risk
Some key lessons for financial institutions from the financial crisis are that:
>> Companies accepting and transferring risk should assess the impact on their business if they are no longer able to transfer this risk
>> Simply repackaging and renaming a risk does not remove the risk altogether
>> Rating agency assessments are as fallible as any other long-term financial assessments and should not be used to abdicate risk management responsibilities.

For non-life insurers this is likely to lead to:
>> Greater focus on counterparty risk and a likely resurgence in the syndication of risk among a pool of (re)insurers at the expense of its transfer to a smaller number of highly rated players n Greater focus on the business model of trading risk via facultative reinsurance
>> Greater management focus on mismatches between losses-occurring reinsurance and risk-attaching insurance, especially when written on a multi-year basis in classes like construction and political risk.

The perceived regulatory failures that did not prevent the crisis in the banking industry have led to a wide range of proposals for future regulatory reforms. Many of these proposals as currently drafted apply across the financial services industry, including insurance. Insurance trade bodies such as the ABI and CEA have already warned publicly against the risk of a one-size-fits-all approach to financial service regulation. However, with the role that major insurer AIG played in the crisis, notwithstanding that the failures occurred where it acted in a quasi-banking capacity, it seems inevitable that part of the regulatory backlash will impact on the insurance industry.

Likely medium-term effects include:
>> A greater focus on modelling of risk but with greater scrutiny of the output of complex models and a requirement to test this output using stress and scenario-type testing
>> A focus on any insurers considered intrinsic to the financial system
>> An attempt to move regulatory regimes to anti-cyclicality
>> A move to greater global co-ordination nothwithstanding a short-term trend to local supervision
>> A focus on remuneration policies and their alignment with sound risk management
>> A backlash against jurisdictions perceived either as tax havens or weakly regulated.

Capital-raising and industry trends
The capital needs of Lloyd’s insurers, partly driven by exchange-rate fluctuations, have proved one of the few areas where institutional investors have been willing to respond. Although individually beneficial to those companies, the net effect of this availability of capital has been to mitigate some of the hardening expected in the commercial lines market. After all, it was the availability of cheap and easy credit to both individuals and banks that fundamentally drove the behaviour that eventually led to the credit crunch.

By contrast, the reinsurance market has been firmer in some classes, leaving some direct insurers in a classical squeeze between hardening reinsurance rates and softer direct rates. Many commentators predicted the death of the reinsurance cycle due to mechanisms such as sidecars and catastrophe bonds but, unlike post 2004/05, these have not formed a ready source of capital — in turn offsetting rate-hardening.

The sidecar class of 2006/07 relied on heavy gearing to bridge the gap between the insurance returns available and the return on equity required by the sponsoring hedge funds. The drying-up of credit has severely dampened the formation of sidecars in 2009.

As for catastrophe bonds, the recent crisis should, in the longer term, be the proof of their ‘zero-beta’ and true diversification from standard credit risk. However, the crisis has revealed some flaws in the structuring to date of these bonds around collateral issues for the principal on the bond and the underlying interest paid on that principal. Further, the hardening of the bond market, beyond reinsurance hardening has, at present, led to a disconnect between reinsurance and catastrophe bond prices.

There are reports of the banking industry already reverting to the payment of high bonuses. However, current and future legislative or regulatory intervention at the UK, US, EU or global level is likely to place a limit on the remunerative attractiveness of the investment banking and hedge fund industries to mathematically qualified graduates. Further public anger at the activities of these companies and their effect on the ‘real’ economy is likely to make employment in these sectors less socially attractive. Could the credit crunch represent a one-off opportunity for the non-life insurance industry to increase the calibre of its recruits?

Company strategy
Company strategies will also need to evolve. The requirements of Solvency II were expected to favour larger, more diversified entities, but the recent crisis has caused them to think again. Dispersion of risk should not be confused with true diversification — especially when there is a common driver to risk and especially when that common driver is particularly key in the tail. Banks found that supposedly hugely diversified books were all subject to the same mortgage default and liquidity risks. As another example, some motor insurers allow for diversification between different target markets and different distribution channels but in the tail they are all likely to be driven by the risk of retrospective legislation with a severely adverse effect on motor claims.

The crisis has also shown that the risks of getting into a business that you do not understand have been underestimated, as a number of insurers with financial services operations learn their cost. Further, insurers will need to combine strategic thinking with their risk management and understand the defensibility and adaptability of their strategy if there is a sudden quantum change in economic conditions, institutional arrangement and legislative conditions.

Graham Fulcher is the leader of the Watson Wyatt UK non-life team