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Top Ten threats to the financial strength and stability of insurers…

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Catherine Thomas

Catherine Thomas

Top Ten threats to the financial strength and stability of insurers: AM Best identifies the big challenges,  By James Brewer

Insurers in Europe enjoy a strong capital base, but must be prepared to cope with a series of threats to their survival, experts at ratings agency AM Best have warned.

More than 300 London market practitioners heard a harrowing analysis of the risks when AM Best welcomed them to its ninth annual insurance market briefing on Europe.

The dangers were spelled out in a joint presentation by Carlos Wong-Fupuy, senior director for analytics at the agency, and Catherine Thomas, analytics director.

Five of the top 10 threats were said to be in the category of “knockout punch.” These were a mega-catastrophic event, financial system shock, risk management shortfall, hyperinflation, and rating model error.

In the category of “slow, painful death” were regulation, the market entry of alternative capital, emerging underwriting risk, interest rate spike and loss of entrepreneurial spirit.

Potential examples of a mega catastrophic event were a Los Angeles or Tokyo earthquake, a London or New York City windstorm, and a pandemic or terrorist event. “They can be modelled, but still tend to catch insurance companies by surprise, ” said Mr Wong-Fupuy, citing the way the Thai floods of 2005 had led to bigger bills than anticipated. Even the most conservative insurance companies could be put out of business, he said.

It was argued that on the whole the industry had coped with recent catastrophe loss pretty well, but how would the industry cope with a $300bn blow? “We think a loss of this scale is not unrealistic.” A hurricane like the one that devastated Miami in 1926 could cause losses of between $100bn and $150bn.

Insurance companies should be concerned because catastrophes are the single greatest threat to non-life insurer solvency, said Ms Thomas, because of the rapid and unexpected impact that can occur. Companies have come a long way in modelling their catastrophe risk, but models can vary significantly.

Pitfalls for managements included failure on several fronts – to validate the models, to recognise the limitations of models, to account for perils that are not modelled, and to manage the risk with an appropriate margin of error.

Carlos Wong-Fupuy

Carlos Wong-Fupuy

The AM Best team suggested that companies could seek to manage the risk by adopting strategies including using multiple models and forming their own view of risk; monitoring aggregate exposures; accounting for model error and unmodelled exposures; and purchasing reinsurance protection above the 1:100 or 1:250 return period. A proper margin of error should be built in.

High catastrophe reinsurance layers could be relatively cheap, but margins are under pressure and this may lead to insurers buying less reinsurance protection, the agency cautioned.

Turning to the question of financial system shock, a scenario supposed that interconnected global financial markets suffered a crisis of confidence which drove up the risk premium across multiple classes; stocks and real estate suffered severe valuation losses; liquidity became scarce; credit spreads widened; and asset impairment rose.

But, said Mr Wong-Fupuy, “We think that insurers have learned very good lessons after the [2008] financial crisis.” He added: “The shift into alternative investment is being taken in a very cautious manner, and there is increased focus on technical margins.”

Ms Thomas then analysed risk management shortfall – excessive risk-taking and sudden, unanticipated losses impairing the insurer. This is more of a company-by-company issue, she said, but with standardisation of capital models and risk metrics, the potential existed for an industry-wide view on risk that failed to identify emerging threats to the balance sheet. Poor risk management leads to under-reserving, falure to identify loss trends, and providing unintended coverage.

In a vicious cycle, inadequate reserving led to a false sense of underwriting profit, which led to under-pricing. An ultimate loss of credibility could start a rapid spiral towards insolvency. Underwriting control tended to weaken as a business grows rapidly, warned Ms Thomas, “but overall, we think that the insurers of Europe are managing this risk pretty well.”

Roger Sellek

Roger Sellek

On the risk posed by potential hyperinflation, Mr Wong-Fupuy said that levels of inflation recently have been atypical. Company earnings had benefited from stable reserve releases because of low levels of inflation – for some, 50% of profits stemmed from such releases, “and we do not think this is sustainable in the long term.”

A growing threat was catastrophe model error – there was a danger that event scenarios in models were insufficiently rigorous, for instance in taking into account financial market shock.

On the question of regulation, Mr Wong-Fupuy said that layers of compliance costs could drive small and mid-sized insurers out of the market, and high capital charges could force companies to abandon profitable lines of business. He added: “It is a question of whether insurers are strong enough to influence regulation in a sector dominated by the banks.”

“We expect alternative capital is here to stay, “ said Ms Thomas, “but what role will it have in five to 10 years’ time?” The presence of such mechanisms as catastrophe bonds, ‘side-car’ companies, collateralised reinsurers, and hedge fund-backed reinsurers meant reduced demand for reinsurance, and downward pressure on pricing and terms and conditions. “It is catastrophe risk in peak areas such as the US which is most under threat.  For insurers, the obvious benefit is cheaper reinsurance, ” said Ms Thomas.

Of cyber risk, she said that the potential financial impact could be massive, but cyber- theft, fraud, hacking, and sabotage represented an opportunity as insurance products.

Surveying emerging underwriting risk, she asked: “What would a one in 200 year solar storm do to the power supply? Power failure estimates range from 16 days to one to two years.” Potential economic costs of such blackouts were between $600bn and $2.6trn.

Meanwhile, a sudden rise in interest rates such as of 200 to 300 and more basis points would create a huge unrealised loss in the fixed income portfolios of insurers.

Explaining concerns about ‘loss of entrepreneurial spirit’ as a risk factor, Ms Thomas said that the industry could be mired in layers of regulation, governance and compliance mandates. Too much time might be allocated to compliance-related box-ticking exercises. Countering this, insurers could take action to emphasise the innovation inherent in insurance, invest in new employee training programmes, embrace new technology solutions, and consider new products, distribution channels and buying habits.

The AM Best duo posed the question: Why do insurance companies fail? In the US property/casualty sector between 1969 and 2013, according to the US P/C  Impairment Review of June 2014, 44.3% of failures resulted from deficient loss reserves (inadequate pricing), 12.3% from rapid growth, 7.8% from affiliate problems, 7.1% from catastrophe losses, 7.1% from alleged fraud, and 6.6% from investment problems (overstated assets).

Guest speaker Michel Liès, chief executive of Swiss Re, said industry people were spending too much time worrying about the incursion of alternative capital. Instead more effort was needed to address the 75% to 80% of the planet that was without any form of insurance. “I deeply believe that this industry has fantastic opportunities for growth, ” he said.

The recent London Matters report on the future of the capital’s insurance market called on it to embrace the rise of alternative capital I”n order to take advantage of deep capital markets, build capacity in capital scarce lines and protect against extended soft market cycles.”

AM Best, which has 3, 500 interactive financial strength ratings in issue, has clients in 82 countries. Roger Sellek, chief executive for AM Best EMEA and Asia-Pacific, said that the agency would continue to expand, continuing to focus exclusively on the insurance sector.

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