Some UK motor reinsurers still do not understand the extent of the risks they are accepting.
Selby will be remembered for years to come for the rail crash in March in which 13 people died in a collision apparently caused by a Land Rover crashing onto the tracks. Reinsurers should remember it particularly well: the accident has brought into sharp focus the vulnerability of reinsurers in the UK motor market.
The insurance claims resulting from Selby are expected, even at a conservative estimate, to reach well over £50m. At this stage it is thought that the 13 unfortunate deaths and the many other bodily injury claims will make up the minority of the claim total; clearly third party damage will feature prominently. Assuming the motorist's insurers accept liability, it will become by far the largest motor loss ever in this country, and nearly all the burden will fall on reinsurers.
It is, of course, unwise to draw too many conclusions from a single, extreme incident. Nonetheless, the Selby rail crash illustrates very clearly the exposures being carried by reinsurers, particularly those markets writing unlimited top layer excess of loss contracts. One of the factors that sets the UK motor reinsurance market apart from many others is that the business is predominantly excess of loss. Quota-share capacity is rarely utilised. We think it highly unlikely that the reinsurance underwriters and actuaries in the UK motor market as a whole have built enough margin into the rates to cater for such rare events, even after allowing for a funding period of ten years. Selby will change the market's view of the level of risk it carries, and the commensurate returns required to reward assuming such risk.
It is very difficult for UK reinsurers to consider the Selby loss when, at present, they are already under siege from a number of other areas. There has been considerable comment in the UK trade press about the rising cost of bodily injury claims to insurers. This is understandable, given that our own research for the UK Bodily Injury Awards Study* has shown claims escalation costs of around 13% for at least the past decade. What most observers fail to point out, however, is that the effects on reinsurers have been of an even greater order.
Analysis conducted by actuary English Matthews Brockman demonstrated how a typical excess of loss treaty would suffer when subjected to an increase in claims experience in the primary market. The results were striking, with claims activity to the excess layers magnified several times compared to increases in the primary market.
There are two main reasons for this differential. Firstly, the largest claims, those which tend to concern reinsurers, have been affected more in percentage terms by recent developments. Secondly, the whole process is geared, which ensures that relatively small changes in the primary market mushroom as the reinsurers come into play.
In a rational market this would not matter, as reinsurers would compensate for this increased exposure through the prices charged. Unfortunately, reinsurance rate decreases were commonplace in 1999 and to some degree 2000. The income to reinsurers was further damaged by the rate reductions in the primary market over the period 1997 to 1999. There was, though, a substantial hardening in reinsurance rates at the end of 2000 and during the beginning of the 2001 renewal season. These rises will be on top of the ‘natural' effect of the significant increases seen in primary prices. However, it is doubtful, even now, whether levels are adequate to make a profit – even disregarding the Selby claim.
When considering the future for UK motor reinsurers, it is helpful to start by looking at trends in the primary market. Prices have risen substantially since 1998 when the sector recorded an average loss ratio of 92.2% and a combined ratio over 120%. The prospects for 2001 mean that there could be a return to modest profitability. To stay there, however, the primary market will have to see a sustained period of premium rises well in excess of average price and salary inflation. The reason is simple – a continuing adverse bodily injury claims trend, with a steady upturn in frequency.
Some of the factors driving this trend are of relatively little concern to reinsurers, as they predominantly affect the smaller claims. For example, the increased litigiousness that has escalated the £0 to £15,000 category is hardly apparent at the higher excess levels. Three factors should, however, worry reinsurers. First, there is the possibility of a further cut in the discount rate used to calculate lump sum damages from the present 3% to 2.5% or even 2%. This would have a crippling impact on most motor reinsurers in the UK market.
Second is the threat posed by possible legal developments. Last year, for example, the Court of Appeal considered eight test cases on general damages for non-financial loss, such as pain and suffering. It sanctioned retrospective increases on a sliding scale, rising to 33% for those at £150,000. This judgment was, in fact, considered by most to be quite lenient on the insurers concerned (although no one expects the matter to rest there).
Third are the underlying factors, many of them medical, which have long been behind claims escalation at the higher levels. These include better, more expensive medical care, greater life expectancy for seriously injured people, and a higher propensity for the public to seek accountability for accidents.
In the short run, the prospects are relatively promising. Provided rates continue to swing in the right direction and loss experience remains at a reasonable and predictable level, profits are achievable. The key to an adequate return over the reinsurance cycle, however, is to manage the performance of the portfolio over the downturn.
There are two main ways to achieve this. The first involves getting closer to your client, the primary insurer. Due to the competitive environment, motor insurers in the UK are at the cutting edge of data collection, management information, technical analyses and rating. There is tremendous knowledge to be gained by fully understanding the various risk and exposure analyses carried out by insurers. It is no longer adequate to simply look at a listing of historic large claims. Reinsurers need to ask: what specific exposures generated those large claims? How has the exposure to large claims changed?
Our analysis indicates that the likelihood of a large bodily injury claim emerging from the portfolio of an insurer depends on the exposures within each of the motorcycle account, the fleet account, the commercial account and, of course, the private car account. A key factor for reinsurers in all these accounts is coverage (comprehensive versus non-comprehensive). Each can exhibit markedly different trends.
To a limited extent, the reinsurer is protected from changes in exposures since an increase in a primary insurer's risk profile will be generally reflected by a rise in the average premium per vehicle, which in turn will mean more income per unit of exposure for the reinsurer. The problems arise when an increased exposure to large claims is not fully reflected in the movement of the average premium per vehicle. The classic example is coverage trends: a movement towards non-comprehensive business by the primary insurer may well lead to a fall in average premium, but the exposure to large claims will definitely not have reduced.
A second way to respond to market conditions involves enhancing the level of analysis carried out in-house by the reinsurer. The aim here is to make full use of the data supplied by the primary company, either directly or via the reinsurance broker. Reinsurers, in order to save time, have in the past tended to ask for information at a summarised level. However, sophisticated off-the-shelf rating software now exists that can actuarially analyse motor excess of loss contracts effectively and efficiently. Such software typically models losses and contract terms such as otherwise recoverable inner aggregates.
The UK motor reinsurance market is likely to remain as competitive as the primary market, and reinsurers seeking a competitive edge should look to the primary market for guidance and, in particular, the level of data capture and analysis that takes place. For the market as a whole to achieve long-term profitability, reinsurers must be quicker to recognise adverse trends, quicker to quantify their impact and more confident in taking proactive action.
While it will, hopefully, be many years before we witness another event on the scale of the Selby tragedy, the concern has to be that reinsurers to date have not fully understood or rated the full extent of the exposures that they have been accepting. It seems inevitable, in our opinion, that Selby will prompt a fundamental review of how large losses are funded by the reinsurance market. This in turn will lead reinsurers to review the costs associated with putting their balance sheets at the disposal of their clients.
* Second UK Bodily Injury Awards Study (October 1999), published by the International Underwriting Association.