UK: Insurance Market Update – December 2005 - Industry Trends

To insurance industry executives

This past year the insurance industry has faced a number of challenges – investigations into market practice and regulatory pressure to drive forward operational processes and then to be hit hard by a series of natural catastrophes. With the devastating impact of Katrina, Rita and Wilma it is easy to forget that in 2005 there were other serious weather related incidents, for instance Dennis and Emily, which have impacted balance sheets.

Katrina is being talked about as the worst ever loss to the market – notwithstanding the contentious issue of damage caused by wind or flood. The after shocks that this will present the market have yet to be felt. Initial loss estimates seem to have been underestimated and with revisions to these estimates, reinsurers are exiting the market and rating downgrades are a regular occurrence. On the positive side in Bermuda (and in London and America) we have seen a rapid reaction with new capital being raised and a small number of new market players supported by private equity hoping to capitalise on an increase in prices.

In this issue we carry a number of articles of current interest, some with a focus on lessons learned, within a landscape that is subject to regulatory and external scrutiny:

• In the past decade the economic environment was characterised by dramatic change and widespread uncertainty; rapid technological advances; fluctuating consumer confidence; and intense global competition. All of these factors are profoundly destabilising – add in one-off events such as the Asian financial crisis, 9/11, earthquakes and hurricanes and it’s easy to understand why volatility has become a constant. Our research Risky Business? Managing risk and creating value in a volatile world examines UK plc and finds that firms in the UK are indeed at greater risk to shareholder value volatility – requiring protection by way of greater risk management and creating a value cushion. Chris Gentle outlines the results of this research.

• Financial engineering or mis-engineering has been in the spotlight over the last year. Regulators have been investigating individual companies and individual transactions and in some cases, individuals themselves, with vigour and tenacity. The principal concern is that some transactions have been designed to obscure the view of the financial position. However, the use (and abuse) of non traditional reinsurance is not necessarily a new practice. Kevin Elliott reviews the latest developments and notes that new financial deals will require more explanation to demonstrate compliance with regulatory and accounting requirements.

• The Individual Capital Adequacy Standards regime in the UK has now been in place for nearly a year and the debate has changed from discussing the proposals to calculating the number. This is set to change again over the next couple of years as to how to embed a firm’s capital calculations into their risk management processes, what the FSA calls the "Use Test". As we shall see, Roger Jackson explores some of the potential consequences on key stakeholders of embedding this new prudential capital regime.

• Treating Customers Fairly is a major priority for the FSA, and the industry as a whole is responding. The principle that firms must treat their customers fairly isn't new, and to most seems like an obvious course of action that makes good business sense. Rebecca Thorpe summarises the issues affecting the general insurance industry and comments on the FSA’s recent survey as well as providing a shopping list of our findings of current practice.

• General insurance intermediaries are well into the first year of FSA regulation, and many businesses will have undergone significant change improving their control environment and ensuring compliance with the FSA’s detailed requirements, the impact with which the industry is now coming to terms. Many firms will be now turning their attentions to their first Arrow visit, whilst a minority will be out the other side and attempting to deal with the challenges of their risk mitigation plans. Mark McIlquham describes our experience of the process and offers some useful points for firms to consider prior to a visit.

• The average value of personal injury claims has increased over the last decade. A key factor has been the increasing number of people sustaining a "no fault" personal injury to seek compensation – to some extent fuelled by "no win/no fee" legal advertising. The primary focus for reducing personal injury claims costs is mitigating legal and medical costs. James O’Riordan and Andrew Power argue that this is a problem that must be addressed. Whilst insurers manage claims as a volume business rather than as a value business, the drivers for claim inflation are more than how well claim volumes are managed and the rate of claim settlement throughput – the key will be to manage more effectively the broader claims supply chain.

• The term run-off is a very undynamic description of an industry that is growing at a tremendous rate attracting new entrants in pursuit of extracting value from discontinued lines of business. The introduction of Part VII transfers under the Financial and Services Markets Act 2000 has led to the creation of leading edge solutions. Alex Marcuson looks at the current position on Part VII transfers and the lessons that can be learned from those transfers that have taken place under the new legislation.

• In addition to our usual technical updates: we bring to your attention the latest European Directive on reinsurance providing scope for regulation of reinsurers as well as offering access to the European passport; we introduce the London market initiative on contract certainty; and we comment on the VAT implications on outsourcing. All these issues will have an increasing practical impact on the operation of the market over the next year or so.

We hope that you find this interesting. We would also appreciate any feedback you may have on this publication so we can ensure we focus on those issues which matter to you. For further information please address any comments or suggestions either to Jeremy Casson or Kevin Elliott.

The events witnessed in the USA continue to grab the headlines. Hurricanes Katrina, Rita and Wilma, among others, have had a huge human and business impact. They provide a microcosm of the huge variety and types of unpredictable, one-off shocks that insurance companies face today and increasingly face in the future. The resilience of a company’s share price (or shareholder value) to the impact of major events is something executives need to better understand – by continually refreshing risk management and value enhancing strategies. Investors and executives share a mutual desire for the success of their company, but they also harbour a common fear: a significant drop in share price or shareholder value. Unfortunately, unlike many concerns, this phobia is grounded in reality. Steep market drops affect a significant percentage of companies, encumbering them with negative repercussions that can last for years.

Indeed, over the last decade, almost half of the 1,000 largest global companies suffered declines in share prices of more than 20 percent in a one-month period, relative to the Morgan Stanley Capital International (MSCI) World Index. By the end of 2003, around a fifth of these companies had still not recovered their lost market value. Another one-quarter took more than a year for their share prices to recover.

Although each of these companies experienced unique circumstances that contributed to their loss of value, there are several common underlying risk factors that resulted in a negative effect on value.

The process of value creation is central to building a dynamic and competitive economy. Three major trends tend to influence the value creation process. First, volatile market conditions have had a polarising effect on the ability of companies to create value. Second, there is a stark difference between the strategies of value creators and those companies prone to destroying value. Third, market liquidity tends not to strict growth. For instance, the liquidity of UK markets has grown in absolute terms over the last decade. Further, a handful of UK companies have gone literally from zero to hero, from FTSE 250 to the upper echelons of the global 100 – witness the rise of The Royal Bank of Scotland Group and Vodafone.

Further analysis of the response of UK listed companies to one-off events is particularly instructive for financial institutions to feed into running their own businesses.

The last ten years have proved extremely turbulent for UK listed companies. The lesson for their managers is that value is and will always be at risk from unexpected, unavoidable (internal and external) events. However, value can still be created in this volatile environment and it is critical to access a value creating, rather than value destroying spiral.

Value creators

We found from our analysis of UK listed companies compared with a global basket of listed stocks between 1995 and 2005, that the most value creating, resilient UK companies focus on long-term risk management strategies which build material value for their stakeholders, e.g. brand, reputation, unique organisational practices and strategies. Even in the face of a one day value loss, typically caused by an external shock event, value creators continue to emphasise the positive, focusing on value creating external market opportunities more often than on risk factors founding the external marketplace. By focusing on value creation these companies are able to build a "value cushion" that help to protect them from volatility and risk – and even more crucially, allowing them to have a significant bounce back capability, enabling them to recover from one-off shocks. These value creating companies go on not only to recover any value lost, but also to add further value.

Value destroyers

By contrast, value destroyers, the least resilient UK companies, focus on short-term tactics that may shield themselves from outside risks, but do not build long term value for their stakeholders. They lack the capability to build and manage the resilience-creating intangible assets, such as unique business practices, strong brand and robust information flows. In fact 80 percent of value destroyers have never fully recovered their lost value.

Our research shows a contrast between value creators and value destroyers that could not be starker. Future success of UK companies rests on careful integration and equal treatment of tangible and intangible assets within a value orientated strategy.

UK-listed businesses in the FTSE 100 and FTSE 250 experienced more volatility than their counterparts in the MSCI World Index. However, there is an intrinsic volatility for smaller listed companies which could raise governance issues. This makes long-term communication strategies with stakeholders particularly important.

The value losses for UK companies were generally greater than their international counterparts. British equities were also less likely to recover their value within a year. Even more important, research found that one quarter of UK firms that suffered a one-off shock have yet to recover their lost value – which helps explain why life at the top has become increasingly perilous for Britain’s executives.

Our research shows that smaller listed UK companies have experienced the greatest volatility. Over the past ten years, nearly half of FTSE 250 companies experienced one or more events where they lost at least a third of their value – compared to roughly a quarter of the FTSE 100 companies. As a consequence, some FTSE 250 companies may find themselves sucked into the vicious spiral of dependency on short-term share price movements – a dependency that makes them overly risk averse, and ultimately perpetuates their volatility. This may appear an odd discussion for those who are familiar with the UK market. Recently, the FTSE 250 has hit record levels. This merely emphasises the point that senior executives should not rest on their laurels.

Running a major business has never been more challenging. Over the last decade, for instance, UK-listed companies endured more volatility than their global counterparts – making it exceedingly difficult to achieve their business goals and deliver sustained performance. Running a FTSE 250 listed corporate in the UK has been even tougher. Not only has the FTSE 250 experienced more volatility; smaller companies are even less likely to recover their lost value. Overall a quarter of the firms we studied never regained their original value. For most boards, this is an unacceptable result – and is likely to make the position of CEO or CFO tenuous at best. Action is required.

It is imperative that the management team immediately address four key issues:

• strong and consistent value creation messages around the strategic, operational, financial and market activities need to be developed;

• a robust buffer between the business and the volatility and risks of the market needs to be enhanced through the development of intangible assets. Although intangibles form a sizeable proportion of the shareholder value in a business, they are all too often neglected in favour of shorter-term responses to perceived risk;

• communication to all stakeholders – assessing, influencing and participating – needs to happen on a systematic and continuous basis; and

• the management team must not deviate from this strategy when unavoidable, unpredictable events hit the business.

Similarly, there are some actions that need to be eradicated from the business. Value destruction can be self-inflicted. In the face of volatility the business should not turn inwards and focus on risk mitigation, or overly focus on tangible assets alone. Investors are not the only important stakeholders in the business – it is important to also focus on internal communications alongside market messaging.

To create a virtuous, value-based risk management circle it is important to incorporate four key components into any strategy:

• re-think risk management on the basis of a complete picture of a business. Every constituent of value must be identified and its risk assessed;

• understand the different types of stakeholders, and how each assesses a company’s value. Prioritise accordingly;

• build value prioritisation into a risk management strategy; and

• monitor continuously.

In summary, now is the time for a serious debate around the issue of why value is more at risk for corporates in the face of extreme events. For instance, why is it that UK corporates are more prone to value loss due to market volatility? How do we compare with other major market economies?

It is imperative to understand in more detail what best practices can be deployed by UK companies to ensure that the value creation process becomes less risky in the face of extreme events. Rising volatility and extreme events do not mean that UK companies – large or small – cannot create value. A comprehensive approach to value and risk identifies and protects a business’s long-term value. By following such an approach, a business can always turn risky business into valuable business.
Article by Christopher Gentle

The FSA’s current consultation (CP05/14) on financial reinsurance agreements – financial engineering – reflects an enduring concern in the UK, and elsewhere, that such structures may be used to confuse and even mislead the understanding of the underlying financial position of an insurer. Central to the issue is the degree to which arrangements transfer risk to the reinsurer, if at all, and the way that undisclosed terms, side letters or contingencies may be used to change the substance of the arrangements. With the intensifying demand for accounting value to reflect real economic value it is clear that these arrangements will be subject to ever closer scrutiny and that companies employing them will be expected to offer greater transparency. Kevin Elliott and Jeremy Casson investigate.

Non traditional reinsurance – financial engineering – including so called financial, finite, structured or alternative risk transfer – has been in the spotlight over the last year here in the UK, the USA and in Australia. Regulators have been investigating individual companies and individual transactions and in some cases, individuals themselves, with vigour and tenacity. Information requests have been made, reviews instigated and even financial statements have been re submitted with a consequent impact on earnings and share price. Regulators are concerned that some non traditional transactions have been designed to obscure the view of the financial position arising from their accounting treatment.

However, the use (and abuse) of non traditional reinsurance is not necessarily a new practice.

In the 1950’s syndicates within the Lloyd’s market were using certain reinsurance contracts of which Lloyd’s of London did not approve. Market letters were sent out in 1955 and 1958 with other letters sent in the first half of the 1980’s. These "improper reinsurances" which were reinforced to the market in 1990 did not constitute a comprehensive list of such reinsurances:

• inter – open year reinsurances;

• excess of loss contracts whereby balance of premiums not offset by losses could be carried forward ie spread loss or multi year;

• tonner policies;

• fronting on original terms for those companies which would not be able to underwrite directly for regulatory, tax or other reasons;

• roll – overs; and

• time and distance policies.

The governing principles were then laid out in order to ensure that the substance of such reinsurances was in accordance with insurance and agency law. Because each year of account was a separate venture an overriding requirement (in the Lloyd’s market as opposed to the company market) was that the reinsurance should be in the best interest of, and equitable between, Names and be properly accounted. Equity between Names was a paramount consideration in determining any long term relationships with reinsurers and any multi year contracts should not have given advantage to one set of Names to the detriment of another set. It was concerns about compliance with this concept, together with inappropriate accounting and disclosure, which helped to bring the use of such contracts into the spotlight in the Lloyd’s market and subsequently in the company market.

In the company market the then regulator the Department of Trade and Industry (the DTI) in 1991 reminded the market of best practice for those companies which were making allowance for investment return in calculating their loss provisions. In 1992 the DTI wrote to the company market reminding them of their responsibilities for recognising liabilities arising under spread loss contracts. Later in 1992, the DTI issued guidance on disclosure of such contracts within the regulatory returns and noted that financial reinsurance may take various, often complex, forms under a range of names, including finite risk insurance.

Insurance risk is characterised in a contract which indemnifies the insured against loss, liability or other consequence of an adverse event by the insurer on payment of a premium and there is uncertainty as to whether the loss event will occur or what cost it will have (underwriting) or when it will occur (timing).

Insurance risk should be inherent in the contract – be it underwriting risk or timing risk. However, insurance risk will not exist in respect of contracts where the insurer’s risk is no more than a lender’s return under all circumstances.

A contract of reinsurance should also be one of indemnification with risk bearing characteristics and with a degree of uncertainty as regards the level or timing of losses. A reinsurance contract is an agreement between a ceding company and the reinsurer whereby the reinsurer, for consideration received, assumes all or a proportion of the ceding company’s risk. Note that there is transfer of risk.

There is no prescriptive guidance on what constitutes adequate risk transfer. In the USA a 10/10 rule of thumb has been used by some firms – a 10% probability of a 10% loss. The assessment of a loss probability should be based on the net present value of cash flows anticipated under the contract, by development of:

• a single scenario via judgment that could be viewed as a reasonably possible outcome; or

• a single scenario inherent within the policy limits; or

• a stochastic simulation model of a series of scenarios.

Invariably appropriate actuarial, accounting and legal expertise is required to assess and account for these contracts.

Guidance on UK accounting treatment is set out in the ABI SORP on accounting for insurance business and within a technical release on the application of FRS5 to general insurance transactions. IFRS 4 – accounting for insurance contracts – may also be applicable to some insurers.

A key characteristic is the transfer of risk. There will be no transfer of insurance risk where the contract provides for the reinsurer to receive no more than a lender’s return under all reasonable scenarios. Is it reasonably possible that the reinsurer may realise a significant loss from the contract and whether there is a reasonable probability of a significant range of outcomes from the contract? This assessment should be made prospectively ie at the time the contract is entered into. The contract should be accounted for in two parts if there are elements readily identifiable that do or do not transfer risk. How this "bifurcation" or "unbundling" has been considered in practice is not readily apparent.

In a nutshell, where there is sufficient risk transfer, the reinsurance premiums payable and reinsurance claim recoveries would be accounted for as insurance and recognised within the underwriting account. Where there is no or insufficient risk transfer the reinsurance premiums would be accounted for as a deposit within the balance sheet.

It is the result of this judgment of what constitutes sufficient or significant risk transfer that can obscure the view of the financial position as it determines whether the contract is accounted for as an insurance contract or as a deposit. However, the more prescriptive any test for risk transfer would become then there is more scope for abuse of the concept of "substance over form".

Because the UK and USA accounting professions, in particular, have developed accounting guidance it has been encumbent on the accountant to be the gate keeper to ensure that an appropriate assessment of risk has been made in order to determine the accounting of the contract.

There is no universally accepted single definition of financial reinsurance – but essentially they are contracts which transfer a restricted amount of risk to the reinsurer.

Indeed the term may be mis-used and mis-understood since such contracts can take a variety of forms and are often complex. Characteristics of such contracts can include an element of direct or indirect profit sharing; multi-year; multi-risk; retrospective; prospective; experience accounts; dynamic pricing; time value of money; or limitation of risk especially underwriting risk.

Insurers enter into financial reinsurance contracts for capital management as an alternative for traditional excess of loss reinsurance; to smooth profits or spread losses over a number of years; to create hidden reserves; to strengthen loss reserves; or to accelerate the recognition of investment income – basically to remove volatility from their results over a period of time.

It can be a valid method of strengthening a firm’s solvency position where there is a genuine and material transfer of risk to an unconnected counterparty. The success of such contracts is dependent upon the accounting treatment.

The thrust of the DTI’s guidance in 1992 was that there should be no possibility that a user of a regulatory return could be confused as to the true position of the company. Nothing changes – advance forward to 2002 and 2005 and the FSA has noted in consultation papers that concerns arise over financial engineering when its use obscures the underlying financial condition of a firm or is designed to mislead consumers or regulators.

The key is to understand the nature and intent of the contract. Because so called financial contracts are bespoke and complicated and sometimes inter related with a series of other contracts (or even subject to side letters altering the intent) it is sometimes not transparent to a third party as to the true substance of the contract and whether sufficient risk transfer has been achieved.

The abuse lies in designing contracts whereby it appears that there is sufficient risk transfer but in reality there is no risk transfer – which determines whether the method of accounting is revenue or balance sheet based. This has a consequent impact on the view of the financial position of the insurer. It is this aspect of financial reinsurance that is being closely scrutinised.

The FSA have highlighted concerns that financial reinsurance transactions may be used to obscure the underlying financial condition of a firm. In March 2005 the FSA wrote to large and medium sized insurers, as well as managing agents at Lloyd’s, reminding firms of their responsibilities and requesting a report on their use of financial engineering including finite reinsurance transactions to include the following information:

• the extent of transactions where the economic value of the transaction differs materially from the value placed on the transaction in the balance sheet;

• the systems and controls to subject such transactions to adequate scrutiny;

• confirmation that the firm is satisfied that it does not engage in financial engineering transactions or side agreements that may obscure the firm’s financial position or put the firm at risk of breaching any applicable regulatory requirements; and

• confirmation that the individual capital assessment explains the extent to which financial engineering has been used and the impact on assets and liabilities and capital is allocated to mitigate such risks.

Following their analysis of the reports the FSA included its response via its quarterly consultation paper CP05/14 in October 2005. The FSA commented that although its use was not widespread their work had "identified a small number of contracts that warranted further examination" and that they would take action where firms had made improper use of such contracts or not made disclosure. The consultation paper notes that there are concerns that firms (companies and syndicates at Lloyd’s) may enter into financial reinsurance agreements and transactions where:

• the credit taken is not commensurate with the economic value added after taking account of the level of risk transferred; or

• there may be undisclosed terms in the agreement, or in some related agreement or side letter, or contingencies that have the potential to render the arrangements ineffective or to materially affect their value; or

• firms may not have analysed the full effect of the transactions on their current and future financial position.

Accordingly, the FSA are proposing extensive disclosure within the public regulatory returns in order to provide the market with confidence that there is sufficient information to allow a proper assessment of a firm’s financial position and that all risks relating to the use of such transactions have been identified. Information so disclosed would also inform the Arrow visits and subsequent risk mitigation letters.

The FSA’s investigation into financial reinsurance and the new guidelines will help insurers understand the importance of controls and disclosure in relation to such contracts. The disclosure which will be in the regulatory returns, but not the financial statements, will be triggered only if the financial effect of the contract on capital resources is material. This is to be defined as the financial effect of the contract on both assets and liabilities being greater than 1% of technical provisions. However, a contract falling under that threshold whilst not material to capital and solvency may actually have a material impact on the insurer’s profit and loss account for the year. Prior to the publication of this consultation, the International Underwriting Association of London (IUA), issued guidance to its members on the systems and controls firms need in place to comply with FSA requirements.

In August 2005, the American Academy of Actuaries presented a report on risk transfer to the casualty actuarial task force of the National Association of Insurance Commissioners (NAIC). Furthermore, NAIC have recently approved enhanced disclosure of the terms and objectives of the use of such financial contracts which have the effect of altering policyholder surplus by more than 3% or that represents more than 3% of ceded premiums or losses. The company’s CEO and CFO must also attest that there are no side agreements.

At the conclusion of its annual meeting in Vienna in October 2005 the International Association of Insurance Supervisors (IAIS) issued an insurance supervisory framework and other standards for the supervision of insurers, including a guidance paper on risk transfer, disclosure and analysis of finite reinsurance outlining the key related areas on which regulators should focus.

Whilst it is generally accepted that there can be legitimate reasons for the use of financial reinsurance, their abuse has been making the headlines. For new financial or finite deals to be acceptable there will need to be more structure contained within them in order to demonstrate sufficient risk transfer and to match economic value with accounting value. They will need to be accounted for and disclosed appropriately – and the level of scrutiny by brokers, accountants, regulators, rating agencies and investors will increase.
Article by Kevin Elliott and Jeremy Casson 

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