While the past may be our best guide to the future, it offers no assurance that the increased severity we are seeing in claim costs is under control, says Thomas Greene, head of casualty – reinsurance, Liberty Mutual Re
There’s a scene early in the classic film noir thriller Double Indemnity when Fred McMurray drives away from Barbara Stanwyck’s house mulling over the prospect of murder. In his rear windscreen, we see the superimposed, rather shaky footage of a receding Californian highway. This was standard fare for 1940s film-making. But as sophisticated 21st century viewers, we know that McMurray is sitting in a studio-bound set looking at a scene that bears no relation to the one supposedly playing out behind him. Ah, the magic of cinema – and perhaps also a flaw in current reinsurance thinking.
Double Indemnity is one of the few great movies in which insurance, albeit life insurance, plays a prominent role in the plot, hence my familiarity with it. But the scene in question also serves as a metaphor for something that concerns me greatly about the reinsurance market’s world view, namely the correlation between past experience and future losses. And while the past may be our best guide to the future, it offers no assurance that the increased severity we are seeing in claim costs is under control.
Let me give you an example. Imagine a scenario in which a pregnant mother and her unborn child are killed in a tragic auto accident. It’s a heartbreaking story, but one that does happen – and it demonstrates what we are seeing on the severity front. Five years ago, a case like this would likely have settled for, say, $2m. Today, we could expect an outcome that tops $10m – five times the amount of just a few short years ago. This type of claims inflation is commonplace today – and is potentially a huge problem for our ceding company clients, and for reinsurers trying to price risk fairly and effectively.
The rise of settlement values relating to commercial auto insurance is well publicised, but we are seeing similar increases across all lines of business. General liability and excess liability classes, product claims, D&O, professional liability exposures, medical malpractice and healthcare classes are all experiencing the ever-dreaded ‘frequency of severity’. Once upon a time, a buffer layer used to be a $500,000 excess of $500,000 layer. Now we wonder if a $1m primary policy is sufficient. A million bucks ain’t what it used to be!
The forces driving this inflating severity are varied and well documented: distracted driving and more crowded highways; equipment and materials that simply cost more to replace; ever-expanding theories of liability and duties of care; the rise of social media coupled with a 24-hour news machine that creates heightened public sympathy and more liberal juries; and, of course, the ever-aggressive plaintiff bar. Even the most routine claims cost more to resolve. It may not sound like much for a claim to increase from $60,000 to $90,000, from $180,000 to $240,000, or $4m to $5m – pick your numbers – but these are big changes in percentage terms. Multiply these across your portfolio or the industry and you can understand that these increases are extremely concerning.
This growing disconnect between historical experience and future settlement values adds even more uncertainty to the mystical art of reinsurance pricing. As an industry that relies heavily on actuarial data, we have much in common with Fred McMurray pretending to drive his studio-bound auto. Yes, we can look behind us to see where we’ve been, but that does not tell us very well where we are going. Historical data may be the best tool we have to judge the future, but it only serves as a guide for what we might expect. That makes it super important to stay on top of emerging loss trends, changes in policy terms and conditions, what’s happening with rates, and so on. We can look in the rear-view mirror all we like, but it sure won’t help us steer a course around an approaching bend in the road.
In fact, the claims inflation we’re seeing may be just the tip of the iceberg. Only now is our industry starting to recognise this growing severity. Throw in some 1970s–80s-styled inflation and we’ll really be in trouble! The low interest and inflation rates of recent years have been baked into the pricing of both our primary insurance customers and the reinsurance products we sell. Flat-to-declining frequency and manageable severity trends have been the modelled assumptions for the past decade. If rates rise by just a couple points, and severity follows, overall reserve levels will be ‘challenged’, to put it mildly.
I always chuckle when I hear the people talk about ‘the foreseeable future’. What does that mean? Exactly how much of the future is foreseeable? It’s always some indefinite period, because of course we just don’t know. I am not sure that the foreseeable future extends much beyond what’s being served for tonight’s dinner.
So, how do we deal with this uncertainty? At Liberty Mutual Re, we will continue to emphasize analytics in everything we do – examining prior loss history, rate and exposure information, changes in coverage – but also looking behind the numbers to gain a full understanding of the client’s story. We will get into how changes in a client or prospective client’s executive management, underwriting or claims management may be expected to impact the numbers. Within our casualty book, our focus is on programs in which the company or programme manager has the marketplace presence, and the necessary tools and resources, to compete effectively in his or her chosen areas of business. Our partners typically have specialised or distinctive product niches or distribution channels. This gives us an appetite ranging from large national programs to new business start-ups. It’s still a relatively simple formula – sound fundamentals and fairness in the relationship. We’ve found that these things will ultimately win out on the road to success.
This rising severity trend may not have shown up as yet with its full vengeance, but we are seeing ‘reserve adjustments’ in many books and classes. The earnings drag from such corrections will ultimately lead to lacklustre returns, dissatisfied shareholders and more M&A. Companies are far better managed today than in years past, but if they are to avoid being whipsawed by escalating claim costs, they need to be realistic that loss reserves quickly and accurately reflect expected ultimate outcomes. Time to buckle up!
Like Fred McMurray gripping the steering wheel of his car, if we spend a little less time staring into our rear-view mirrors, we may have a chance to navigate the course ahead.