Out of the frying pan?

The past 12 months have seen former financial certainties shaken as never before. Risk managers have important decisions to make as we enter what may be the first truly global recession. The current economic turmoil adds considerably to the challenge of successful risk management and underlines the vital importance of understanding counterparty risk. How may your insurers’ financial stability be threatened? What does diminishing capital adequacy mean for you? And how you can best respond?

Insurance companies fared better than many other financial services organisations during 2008. While scores of banks failed, not a single major insurer went to the wall – though there were a few close calls internationally and it would have been a different story in the US but for the intervention of the US Federal Reserve Bank and Treasury.

Many insurers took massive hits last year – particularly on the investment side of their balance sheets. Formerly impregnable bastions of capital security saw significant downgrades from the ratings agencies, and further downgrades can be expected as the rest of 2008’s full year results come in. Last year saw only a handful of upgrades – Hiscox, Fairfax, Axis among them – and the chances of many following in their footsteps this year look slim.

The falls in share values following publication of the full year 2008 results that have come through so far this year, have been even more dramatic. The new realities are that carriers are facing plunging profitability, rising combined ratios, and that the current insurance surplus (capital), while still plentiful, is falling.

In the analysts’ commentaries, every silver lining now seems overhung with storm clouds of foreboding. During the first three quarters of last year, US insurers’ combined ratios climbed to 103%, up from 95% the previous year, with European composite reinsurers close to 99% compared with 92% the year before.

The chart vividly displays the insurance sector’s declining capital strength. It fully justifies risk managers’ growing awareness of the counterparty risk their organisations are taking on whenever they buy insurance.

The US government may have concluded that allowing the biggest carrier in the US to fail would remove a cornerstone of its economy, and declared it unthinkable. But would the same logic apply to carriers a step or two down on the scale of unthinkability? Almost certainly not.

So what does this mean for your organisation? What confidence can you have that your corporate insurance providers will be there to pay out in the event of major claims? What provisions should you make for the possibility of security rating downgrades?

Insurers’ more conservative investment strategies have left them less vulnerable to the general economic malaise than other financial services entities. But as one giant enterprise after another has fallen to its knees, it is clearer than ever that global economic realities have shifted and nothing can be taken for granted.

How well do you really know the insurers on which your organisation’s financial well-being may depend? The convoluted structure of many carriers makes it hard to understand what really stands behind your policies. Tracing your counterparty risk through layers of different entities and subsidiaries is an inherently complicated process. Nor is the picture ever static for long, as insurers implement restructuring exercises to shift the locus of risk within their businesses.

Looking for clues

In the light of recent events – notably the near fatal effect of credit derivative swaps – many insurers are currently looking to get out of risky, non-core and unprofitable lines of business. This requires constant detailed monitoring. But there are broader clues to look for.

The quality of an insurer’s management is a vital consideration. Key things to look for here include the stability and longevity of the top team, their track record for generating consistent results, and their attitude to investment risk.

It is also well worth reviewing the stance a particular management team has historically taken to issues such as claims management and also its attitude to so-called ‘non-core business’. One thing you do not want to be is a ‘non-core‘ client.

Understanding your insurers’ long-term financial goals – and the shareholders whose interests they ultimately serve – is equally vital. Different investor expectations can drive very different modes of corporate behaviour.

Then there are more specific puzzles to unravel such as the distinct identities of Lloyd’s syndicates and the managing agents responsible for determining their strategies. Where should you be looking to understand the security behind your corporate insurance cover?

“Many insurers took massive hits last year – particularly on the investment side

Again, when an insurer stops writing a particular line of business, run-off managers will have very different agendas and security priorities than active underwriting entities.

Despite their apparent inability to have anticipated many major insurers’ current difficulties, the big four credit ratings agencies – Standard & Poor’s, A M Best, Moody’s and Fitch – remain a key point of reference. But notwithstanding moves to counter the perception that ratings agencies’ revenue models undermine objectivity, the view that their assessments alone provide an adequate guide has fallen firmly out of fashion.

There are many other sources of information available when assessing counterparty risk. Insurers’ stock prices will always be an important measure. Do your insurers’ prices fluctuate widely or are they broadly stable? What are the analysts saying? Brokers’ security committees pool a wide array of expertise and market knowledge to provide an invaluable insight into changing insurer security profiles.

The headline message to risk managers is to ask tough questions. Do not be fobbed off with half-answers, and keep asking and updating those questions again and again. In the final reckoning – whatever advice you may seek – the ultimate decision is yours.

Apart from securing sound advice and acting intelligently upon it, further challenges await. A very important but elusive consideration is the role of the regulatory environment. Who regulates the insurers to whom you entrust your premiums, and how sharp are their teeth? What is the overall character of the regulatory regime over which they preside, and how strong is their will to enforce it? What statutory obligations do the relevant regulators have?

Sweeping changes to the regulation of Europe’s financial markets were proposed by European leaders on 22 February in the run-up to the G20 summit. Precisely what this will mean in practice remains to be seen. But according to German Chancellor Angela Merkel, it will involve creating a ’comprehensive regulatory framework that covers all financial markets and participants’.

Insurers are sure to make preparations for the impact of this and other regulatory changes – with important implications for those who chose to insure with them. In particular, risk managers should be aware of the potential influence of Phase II of implementing the International Financial Reporting Standards (IFRS) and of Solvency II when these come into force.

It is important to understand and track the differing financial reporting standards of GAAP (Generally Accepted Accounting Principles) in the US and IFRS in Europe. Despite edging closer in recent years, their distinct approaches to accounting practice in general, and to standards and valuation methodologies in particular, continue to require detailed attention.

In October last year the US Securities and Exchange Commission (SEC) introduced broader GAAP guidelines on assessing the market value of securities, moving closer to the European model. With further changes apparently under consideration by the International Accounting Standards board and the US National Association of Insurance Commissioners (NAIC), the general trend appears to be towards greater international harmonisation. But important differences remain.

Creating certainty

In such a fluid and uncertain environment, the risk managers’ task is to create what certainty they can. Potential strategies for achieving this are many and various. One obvious option, though possibly not the most welcome in the present economic climate, is accepting the wisdom of paying slightly more for quality security.

There may well be decisions to be taken over cutting back on certain aspects of coverage to focus insurance spend on the most critical areas. But now is certainly not the time to compromise on the quality of the paper your most essential cover is written on. At the same time, judicious diversification can be an effective way of limiting your exposure to the potential failure of an individual insurer.

Viewing risk management and insurance in the broader business context and taking steps to leverage existing relationships can help minimise your counterparty risk. External advisers should be able to help you understand your organisation’s claims profile and help you assess what may and may not be attainable.

They can also help you form a clear impression of specific carriers’ culture, their claims paying philosophy and their typical speed of settlement – all of which should be factored into your decision making. Consider also making contractual provisions for potential downgrades to your insurers’ security rating.

The reality of counterparty risk is very much a consideration now, underlining the importance of implementing regular reviews and putting escalation processes in place. Of course a minor downgrade to a carrier’s security rating will not generally end up materially compromising your ability to collect, as and when major claims arise. But should such changes ring alarm bells nonetheless? Very much so!

The safest policy – as always, but more so now than ever – is feel the fear, take best advice, and then take all steps possible to mitigate the shifting pattern of risks you face.