Alex Letts suggests that externally-demanded reform could finally bring the market into the 21st century

What percentage of a big insurance group's market value is the reinsurance asset? 50%? 100%? 150%? My research on the latest set of accounts of three of the big groups shows that all three answers are correct. What this proves is that upwards of half of the assets of these insurance companies is reinsurance recoverables. Note that we are not talking about small sums here - anywhere from $5bn to $15bn. It's in the audited accounts so it must be true, right? The reality is that the figures signed off in good faith by the directors may be less solid than one would hope.

Now perhaps you might find this disturbing in the post-Sarbanes-Oxley world where directors can be held much more directly accountable, personally, for liabilities in their own companies. In many ways, it's even worse than this. If you talk privately to group reinsurance directors, they will tell you that even though their role is to ensure that these huge assets are properly protected, the resources put at their disposal to do the job are wafer thin. What's more, the processes for tracking and analysing what reinsurance cover is necessary are not automated and are, at best, unreliable. Not only is the information pretty thin on the quantitative side, but equally so in qualitative aspects. In other words, dig beyond the interrogation about the size of the reinsurance asset and seek comfort on the quality of it - who are the reinsurers, by what proportion, by what security? Once again, the picture is hazy.

It's not that the reinsurance people wouldn't love to have the information but that no one seems prepared to take the pain to ensure that the information can be delivered on demand with some expectation of accuracy. If you sit in some big block in Zurich, Munich or London, you'll probably get a manual feed from each of your 10-50 regional offices (which is a long and painful exercise for the researcher in the region). That will arrive periodically at best, and at worst, just once a year; data dating back 15 years, taken from disparate systems (dating back further) in incompatible formats.

It's your job to make head or tail of it for the group. Meantime, the data - such as it is - gives a picture at one moment in time, but meantime the balance sheets and solvency of reinsurers change, their ratings yo-yo, and the group's claims position with each of them alters. Nine months later, that somewhat dubious analysis is nine months out of date. But you have the responsibility to protect the group's asset. How, one wonders?

One wonders also how these corporate officers sleep at night, knowing that there's a pending tray in some New York attorney's office marked 'Class Action in respect of balance sheet misrepresentation'. It's coming to a courtroom near you, and when it comes, it's going to be very nasty indeed.

Congested regulatory arena

It's not as if the insurance companies haven't got enough to worry about at the moment, and perhaps in light of the forthcoming Financial Services Authority (FSA) regulatory regime, it's not too surprising that not everyone's eye is on this particular ball. New regulations, new compliance and new hassle in the regimented march to risk-based insurance is clearly enough for most companies and their boards to discuss without having to listen to the whinging from the reinsurance department.

Inevitably, if there was an easy solution, the majority of companies would have imposed it. But years of complaints from the reinsurance teams, supported by arguments for cost savings, increased accuracy and better visibility have utterly failed to change the situation. Even the advent of the new web services technologies, which allow data from old systems to be easily transported to new central databases, has not provided the impetus for change. The prioritisation for IT projects has sat with the more high-profile departments.

But for once the law may ride to the rescue and may see that the right steps are taken and fast. If its General Counsel, Andrew Whittaker, is to be believed, the FSA is looking to drive 'smarter regulations' through the industry: "We are developing better sector analysis and regulatory reporting for insurance firms, to allow more timely analysis of data, and have set up a cross-FSA insurance risks group to identify emerging risks across the industry so that they can be dealt with in a timely, proportionate and decisive way."

Lloyd's is taking the FSA seriously. It moved in November 2003 to appoint a Head of Market Reform (Iain Saville, whose background in the Treasury and success in the banking industry suggest he is made of the 'right stuff').

Already the emphasis inside Lloyd's is moving towards electronic process and standardisation to replace the appallingly casual historic market practices involving vague verbal commitments and a marked-up slip for contracts that often expire before the wording is produced, practices recently labelled "pathetic" by Lloyd's Chairman, Lord Levene. The momentum is not just process-oriented, but in terms also of positioning is focusing heavily on contract certainty as opposed to the valid, but not market-shifting, arguments of improved efficiency.

As Nigel Roberts, Managing Director of Aon's Specialty Unit, said recently: "Contract certainty has been an issue that needed to addressed. If it takes six months to produce documentation, it is unacceptable. The client does not know what they've bought; they think they do. And we don't know what we've bought, although we think we do."

A group reinsurance director for a major global insurance company puts it in a slightly different light: "The insurance companies seem blind to the hundreds of millions, perhaps billions of dollars that are being lost through there being no clear understanding of what the brokers have actually agreed with the reinsurers. It's only when the claims disputes roll in that the full picture emerges - and it's usually one that no reinsurance director in his right mind would have ever signed up to. We need business process and wordings, not vague feedback, in an auditable electronic format as the agreements are being reached. Trust me, it's the insurance companies that pick up the tab, which all ends up with the consumers getting clobbered with higher premiums."

Adapting to change

It may seem unlikely, but there is agreement across the industry at management level from Lloyd's, insurers, brokers and also the reinsurers, that the fist of Sarbanes-Oxley and the impending change of regulatory regime in the UK make it worthwhile taking change seriously. Add to this the forthcoming draft EU Directive on reinsurance regulation whose working papers hint at the potential imposition of some legal requirements for better process, and the cocktail for change is increasingly potent.

But whilst legal and financial motivation for change is one thing, implementation is quite another. It is here that Lloyd's, and some reinsurers and brokers also to their cost, ignored the lessons of free market economics (and good sense). In its haste to make change happen, Lloyd's decided that it should be both the market and the IT supplier. It embarked on an ambitious and expensive programme to build the wholesale insurance part of the new electronic infrastructure that the industry requires. With what credentials and with what potential for success, one can only wonder. It has to be hoped that the arrival of Iain Saville will see Lloyd's reverting to its more pedigree role as franchisor, allowing the technology companies to provide the right solutions.

Meanwhile on the reinsurance side, progress has been more positive, but not without pain and casualties. ri3k has built the end-to-end business process for reinsurance contract and accounting administration. This public infrastructure is being used by 112 companies across the industry already, allowing user companies to interlink electronically so that the business that they exchange is matched by a full data exchange. It also supports the rollout programmes to allow historic and current exposure data to flow from regional offices to the group reinsurance teams. The potential exists right now for implementation of the London Market Principles (LMP) slip through quotation to contract placement and administration. This provides a clearly auditable business process, clarity of agreement, instant electronic covernoting and a roadmap towards wording-on-signing.

With the ability therefore to put process in place to better understand the reinsurance asset, and to manage and control the contract quotation, placement and administration process, transparently, indisputably, electronically, the legal position in the reinsurance process seems to be improving.

Corporate officers should soon be able to sleep better at night, but not unless they act urgently to embrace, mandate and implement the new electronic reinsurance infrastructure.