Escalation in current and potential liability exposures is causing reassessment of pricing and reserving everywhere. The international reinsurance market has been hit by a series of unusually large claims, including Continental and Ford's tyre recall in the US, multi-billion dollar US class actions against Aventis CropScience USA over genetically modified corn, and Sulzer Orthopedics for faulty hip replacement joints. In the US, some business sectors particularly exposed to negligence claims, such as nursing homes, are increasingly finding it difficult to obtain any insurance coverage at all in the wake of an inexorable rise in compensation claims.

In the UK, spiralling UK liability claims were blamed initially for the demise of Independent Insurance. However, it appears that prolonged under-reserving rather than escalating claims was the real problem. On 16 June 2001, Independent, the UK's 14th largest non-life insurance company1, was placed into provisional liquidation following the discovery of a massive shortfall in the company's outstanding claims provisions. The speed of Independent's demise surprised regulators, auditors, actuaries, stockbrokers, insurance brokers and, apparently, credit rating agencies. Only seven months earlier in December 2000, the share price of Independent Insurance Group plc had reached a record high. Moreover, less than a week before its collapse Independent could still boast a rating of BBB+ from Standard & Poor's (S&P) and A- (excellent) from AM Best & Co.

Could Independent's demise have been predicted much earlier? Clearly, evidence has emerged in the wake of Independent's failure which would have rung alarm bells had it been previously known in the market. But were there clues in the publicly available information too? Benfield Group's proprietary credit rating analysis model suggests that there were.

Independent's roots trace back to the formation of the New Scotland Insurance Group in 1986 and the recruitment of Michael Bright as Chief Executive. A year later, Allstate UK was acquired from its US parent and the company was renamed Independent Insurance Company. Distribution was via brokers and the company pioneered the concept of preferred brokers that were significant producers of business. In 1993, Independent was listed on the London Stock Exchange. Further acquisitions followed, including La Palatine Assurances SA in France in 1995. Led by the ebullient Mr Bright, the company grew, apparently prospered and built a substantial following in the UK insurance and stockbroking communities.

Growth was rapid. Between 1994 and 1997, gross premium written (GPW) increased by 91% from £279m to £533m, before falling back to £459m in 1999. In particular, Independent focused on growing a speciality liability book of professional indemnity business that included D&O and E&O risks. Between 1995 and 1999, at a time when many insurers were reducing their exposure to liability business in the wake of spiralling losses and new exposures, Independent's liability business increased from 11% to 49% of GPW. The underwriting book was becoming increasingly unbalanced. This would not necessarily have been a problem had the growth been properly funded, however, our rating model suggested that Independent's claims provisions and solvency were being maintained at levels far too low for the changing business mix.

Independent seems to have become a victim of its own success. The pressure to maintain earnings growth and retain its status as the star of an otherwise rather lacklustre insurance sector seems to have been the main motive behind such aggressive gearing. Between 1995 and 1999, Independent's loss ratio2 averaged 54.1% compared to 107.1% for the UK non-life market as a whole. Such substantial out-performance of the market should have been cause for scepticism. This was supported by our analysis of Independent's balance sheet. Outstanding claims provisions (OCP) as a percentage of net premium written (NPW) decreased from 92.5% to 56.1% whilst the UK market average ratio increased from 112.8% to 116.9%, as shown in the table.

Other critical warning signs were to be seen. Independent's solvency margin ratio averaged 49.8% between 1995 and 19993, representing a very aggressive level of underwriting gearing for a liability writer and substantially below the UK market average of 91.1% over the same period. Credit and liquidity risk were also growing. Insurance and reinsurance receivables increased from 24.9% to 55.6% of total assets between 1995 and 1999. Liquid assets decreased from 100.9% to 51.6% of technical provisions. Cashflow turned negative, despite reported profits, and Independent resorted increasingly to realised gains to support earnings. Benfield's proprietary rating model suggested an indicative rating equivalent to an S&P rating of ‘BBB' with a negative outlook based on the 1998 financial year, and Independent was not approved as reinsurance security for Benfield Group customers.

Third party observers had their own reasons for ignoring these indicators. For investment analysts it was difficult to maintain a bearish stance on a stock whose shares seemed on an inexorable upward trend. Insurance brokers found Independent a helpful and accommodating market at a time when liability capacity was shrinking and coverage increasingly difficult to obtain.

Rating agencies too had their own constraints. Policyholders and cedants rely increasingly on commercial ratings when selecting their insurers and reinsurers. The major rating agencies have in turn become increasingly influential over the strategy and in particular the capitalisation of the insurance and reinsurance industry, to the extent that AM Best has been described as the ‘de facto' regulator of the US insurance market. However, this growing influence has its downside – not only are the rating agencies constrained by their commercial relationship with the rated companies, but also by the likelihood that a public early warning of financial distress in a rated company can become a self-fulfilling prophecy as confidence plummets and business is withdrawn.

The growing mismatch between reality and the healthy financial state implied by Independent's ratings has become increasingly familiar in the insurance and reinsurance markets. Australian insurance group HIH went into liquidation on 15 March 2001 with an S&P investment grade rating of ‘BBB-'. The rating had been ‘A-' just five months earlier. Reinsurance Australia Corporation (ReAC) also held a rating of ‘A- (excellent)' from AM Best in January 2000, shortly before the reinsurer went into run-off following very heavy losses. Other examples of the rating agencies' apparent unwillingness to predict financial collapse have been Frontier Insurance Group (US), Reliance Group (US) and New Cap Re (Australia).

Commercial agency ratings are useful indicators published in good faith. However, they do appear to be constrained by inherent conflicts of interest and the sheer scope of their influence at the very times when their views are most crucial to policyholders. Independent's demise cannot be blamed on third party observers, whether in the stock market or the rating agencies. However, the Independent saga does suggest that external opinions, however apparently well-informed, should be treated with caution. Whilst the rating agencies do provide useful insights, they should form only a part of the decision-making process. Benfield Group's proprietary approach to credit rating uses its own model, permitting an objective and independent view using a commercial rating methodology without its conflicts. It also enables Benfield to take a consistent view on companies without a commercial rating, and to react quickly to financial distress scenarios. This helped us to avoid problems with Independent, and provides a valuable enhancement to the service that we provide to our customers.

1 Based on 1999 gross premiums written.
2 Net incurred claims/net premiums earned.
3 Shareholders' funds/net preiums written.