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.