Is the insurance sector in a hard pricing cycle?

The insurance sector is notoriously cyclical, with periods of ‘soft’ pricing alternating with periods of ‘hard’ pricing. After years of soft pricing, the global downturn and the liquidity crisis now seem likely to force the cycle towards a period of hard pricing in which the sector will be able to set whatever prices it chooses.

However, doubt still remains over whether we are going into a hard pricing cycle. Like recessions, the exact moment when the insurance industry flip-flops from soft to hard is best determined with the benefit of hindsight. It is notoriously difficult for insurance companies to force the issue and compel a hard pricing era to develop for the simple reason that this is, in general terms, a price-sensitive market. If one company increases its premiums unilaterally, the competition will eat its lunch and force a correction. The whole industry has to be hurting and capital constrained before a hard-pricing era can properly take hold.

Milking customers
Then, of course, once it becomes generally obvious that premium prices are on the rise, the direction of competition shifts. Instead of trying to buy business by forcing the price down, the insurance companies go the other way and milk the customer for all they are worth. It is this phenomenon that caused Michael Lewis, the former wealth manager whose famous book, Liar’s Poker, is a scathing account of his experiences on Wall Street, to make a very provocative judgement on the insurance industry.

Insurers, he argued in a 2007 New York Times article, only pretend to take risk onto their books when they write insurance; what they really do is charge their clients retrospectively for any losses they have incurred.

So are we going in to a hard cycle or not? Does business need to worry? As John Reed, a senior consultant with Aon’s risk financing team, and Ken Read, technical director in risk management, observe, there is no doubt that all is not well with the insurance sector ­ but neither is it all bad. “Insurance companies are being hit on both sides of the balance sheet,” says Reed, but the sector is still very much open for business in a way that the banks manifestly are not. Then again, the sector may have come through the credit crisis rather better than banks, with some notable exceptions such as AIG. But it is heavily invested in corporate bonds and equities and these portfolios are probably worth 40% to 50% less now than they were a year to 18 months ago.

This matters, because the insurance sector is very heavily regulated: a devalued portfolio materially impacts on solvency margins and underwriting capacity. This, in turn, means less competition, so premiums start to climb.

However, it is still too early in the cycle to know if the signs of hardening that are now being seen in some markets are just temporary phenomena. “If you look on a market-by-market basis, it is still unclear,” says Aon’s Read. On ‘short-tailed’ (year-on-year business) such as property insurance, we are not seeing rates rising at all. But on errors and omissions insurance (such as making material mistatements in the accounts), there are signs of hardening. Similarly, there is a definite increase in the number of claims being reported across all lines of liability insurance, particularly directors and officers’ liability (D&O) insurance.

Not only do people generally become more litigious in a downturn, a whole raft of malpractices and frauds also tend to get uncovered. Read cites Warren Buffett’s famous maxim, “When the tide goes out, everyone can see who has been swimming naked.” If the insurance industry thinks it is more at risk from liability claims, then it will stiffen its pricing for future liability business ­ again, evidence of a move to a hardening cycle.

Matching assets to risk
At the same time, because the sector has taken such a hammering in its exposure to financial stocks, it has a real challenge in finding good ways of matching assets against its longer-tailed risks, such as liability claims. The claims that are coming in this year, Reed and Read point out, will run through the courts for many years before they are resolved and will incur significant expense along the way. Matching longer-tailed assets such as five- and ten-year bonds against longer tailed liability risks used to be relatively easy in that banks’ corporate bonds did the job.

Ashish Kapur, European head of institutional solutions at SEI, which specialises in advising pension fund clients (another sector that needs to match long-term liabilities against long-term assets), points out that the yield spreads on bank bonds in March were being valued at rates which suggest we are going to see default levels four times higher than during the Great Depression.

“This is clearly very unlikely to happen, so what it means is that the market is mispricing risk rather badly. This is good news if you are cash-rich and want to buy bank corporate bonds right now, but it is bad news if you are in the position that so many insurance companies are in, of having a historically long position in bank bonds, because their value has dropped hugely,” he says.

Those who are able to invest right now are getting a great deal of reward for quite a modest level of risk, particularly since the bond spreads are taking no notice of the fact that the UK government has taken huge positions in banks such as Lloyds Banking Group and RBS.

Kapur points out that the anomaly is even more startling in the Australian market, where the government has 100%-guaranteed bank bonds, but the yields have stayed stubbornly high. “It is as if the market thinks there is a reasonable chance that the Australian government will go under ­ and that is extremely unlikely,” he says. Governments ­ especially in the developed world ­ do not generally ‘fail’, they simply print more money (or quantitatively ease, we should now say) and try to inflate their way out of their debt.

What all this adds up to is that the markets are behaving witlessly, which is excellent news for George Soros or Warren Buffett, both of whom specialise in pouncing on market mispricing. But it makes for very turbulent waters if one is trying to figure out whether the insurance sector is heading for real trouble and needs to hit business clients for cash fast, or is just being temporarily inconvenienced. The moral for business right now is, if you have any insurance on any major items coming up for renewal soon, get in and negotiate the best price you can right now ­ before the market moves decisively against you.

Captive audience
As the insurance industry moves from a soft cycle to a hard cycle, it is a safe bet that more large and mid-sized companies will be looking to ‘self-insure’ by setting up so-called captive insurance companies, rather than pay outrageous increases in premiums to the insurance sector.

The overwhelming virtue of captive insurance companies is that you get to keep your money in a vehicle that can lend it back to you, instead of losing it forever to the insurance company. And if the scale of the risk you are self-insuring is too large, you can always put some or part of it out to the reinsurance industry via the captive vehicle, which has the right to access the reinsurance industry.

Channel your resources
If you are wondering where the best place might be to locate your captive, Peter Niven, chief executive of Guernsey Finance, a joint industry and government initiative to promote Guernsey’s financial services sector, says he has the answer. He points out that roughly 40% of the leading 100 companies on the London Stock Exchange, along with 95 of the Global 1,500 companies, have set up captives on the island.

Niven is particularly proud of the fact that Guernsey pioneered the idea of the Protected Cell Company (PCC), a device that has been copied by tax havens all round the world. Basically, the PCC is a way of addressing the fact that smaller companies find it hard to meet the capital requirements involved in setting up a captive insurance operation. Guernsey’s capital requirements are among the lightest around, but it stipulates £100,000 as the minimum capital reserve for a non-life business and £250,000 as the minimum for a life business. A PCC has a central company that is strongly capitalised, which then ‘rents’ out capital to smaller ‘cell’ captives, making it much easier for an SME to set up a self insurance vehicle.

Under fire
However, Niven admits that the sector is sailing into a headwind at present, given the marked increase in anti-tax haven rhetoric coming from the UK, Brussels and Washington.

“To some extent this has always been with us, but now people are talking as if we were responsible for the present global downturn. It’s just baffling. They do not seem to be taking any notice of the tax disclosure agreements we have signed with a range of countries, or the fact we do not have secrecy laws like Switzerland or Luxembourg,” he says.

While no laws have yet been enacted that would paralyse Guernsey’s operations, the noises coming from Downing Street and Capitol Hill are blighting the island’s marketing efforts, as far as its financial services are concerned.

But the island has no intention of shutting up shop unless and until the great powers stamp on it. Captives make sense for many companies and Guernsey remains a great place to site them, Niven insists.