Mark Cole debates whether we are seeing the end of unlimited exposure.

With the public announcement in the UK that Norwich Union and Direct Line have imposed limits for third party property damage (TPPD), it seems that this autumn reinsurers have taken what they hope will be the penultimate step in their long march to remove unlimited exposures from their balance sheets. These current actions can, in fact, be traced directly back to July of 1988 and the disastrous events that took place on the Piper Alpha oil rig in the North Sea. In the past, reinsurers have been accused of being reactionary and of failing to give the insurance market advance warning of changes in underwriting policy. This certainly is not the case as far as unlimited is concerned and there was wide debate in the immediate aftermath of that dreadful night in 1988, when the Piper Alpha oil rig exploded. So, why are reinsurers concerned about the provision of unlimited cover? Why has it taken so long for them to take action? What new influences have been brought to bear on the topic, and where does this leave the insurance market?

The debate

Employers' liabilityAs mentioned before, the current debate about unlimited started in 1988, but even then the reaction was hardly rapid. In fact, despite employers' liability covers being unlimited mainly by market practice, it wasn't until 1995 that a cap was imposed.The Piper Alpha loss highlighted, in the most dramatic way, the exposures that reinsurers were potentially running in their liability portfolios. It was not that worst case scenarios had not been contemplated, but merely that historic claims experience had been substantially below the attachment point for unlimited reinsurance layers, creating a false sense of security. The remoteness of expected loss had clearly been reflected in what now - with the benefit of hindsight - appear to have been remarkably low prices charged for such layers.Piper Alpha raised the spectre of US-style and US-size awards being incurred under European insurance forms that included the unlimited capacity. And the vast majority of any such awards would rest with the reinsurance market. Unsurprisingly, those reinsurers started to feel decidedly uncomfortable. Their immediate response was to instigate accumulation and jurisdiction control measures, but it was to be six more years before unlimited would be withdrawn from employers' liability insurance and other non-statutory classes.

Unlimited capacity The concept of unlimited is complex. On the one hand, it avoids any need to determine adequacy of policy limits, which is ideal for the insured and/or reinsured. On the other, it raises many concerns amongst the providers about pricing adequacy and, indeed, methodology; how to assign a finite premium value to an infinite financial exposure has taxed the very best underwriters and actuaries.The well-rehearsed arguments about limited liability companies providing unlimited liability cover need not be restated. However, until relatively recently, this point has apparently been ignored by regulators, rating agencies and purchasers.

1995 to 2000 In 1995, unlimited cover was broadly withdrawn around the world for non-motor classes where there was no statutory requirement to have such a limit. Several insurance and reinsurance pundits comfortably predicted that unlimited in the widest sense would disappear by 2000. But even then, little happened. Having waited six years to make the first serious change in underwriting of unlimited covers, the reinsurers went quiet. Admittedly the attachment points for unlimited layers had increased several times in the period up to 1995 and prices for top end covers had also been raised. By 1994 the attachment point had reached £10m (or £5m equivalent in other territories), up from £500,000 in 1987, but no further changes were made until 2002 despite it being well known that bodily injury claims were fast outstripping wage inflation.Clearly it was not in the insurers' interests to promote a debate. They needed to provide the direct insurance cover to comply with legislation, and obviously wanted back-to-back reinsurance for as long as it could be provided sensibly. There were no indications that governments were interested in changing the law, and there seemed little appetite on the part of reinsurers or their market associations to take the debate over the heads of the insurers and talk directly with government. Statutory unlimited cover was intended to provide the insured, the consumer or the public with an ultimate safeguard and as such was a highly sensitive political subject. Reinsurers were, in fact, preoccupied with soft market conditions for much of this period. Whereas employers' liability had produced consistently poor results, motor - the main class where unlimited was established by law - had provided satisfactory, if not good, results. The latent claims issue that affected employers' liability was not perceived as a material problem in motor. With high rates of interest and slow settlement patterns prevalent, the volume of business in the motor sector added to its attractiveness.During this period there was an active retrocession market available to reinsurers. Those that felt uncomfortable with their unlimited exposures found a ready market in which to lay off their risks. Again, little thought was generally given to the restrictions inherent in the retrocessionaires' balance sheets, which inevitably were limited in nature.European competition law and the fear of the consequences for breaching the rules constrained the debate to such an extent that even permitted dissemination of ideas and opinions didn't take place.

Recent changesMany influences on the insurance and reinsurance environment have changed in recent years. Governments and regulators, rating agencies, stock analysts, shareholders and customers have all developed a much greater consciousness about the implications of financial security. These concerns bring us right back to the original problem of providing infinite capacity on the back of limited financial resources. Now the debate focussed fully on motor business. Claims and losses also had an impact. Motor insurers had been exposed to large losses such as the French TGV loss, the German Herborn claim and the more recent Mont Blanc tunnel closure. However, 2001 was a pivotal year in many ways and was the direct prompt for a renewed drive on the part of reinsurers to remove unlimited.In February 2001, the 'Selby' accident, in which a vehicle ran off the road onto rail tracks leading to a fatal train accident, occurred in the UK and later that year, of course, came September 11.Initial estimates of £50m for the Selby crash substantially breached the £10m attachment point on the unlimited layer. This immediately drew reinsurers' attention back to the unlimited subject. September 11 started the terrorism debate and reinsurers were quick to point out the potentially huge liability that might arise in some countries from terrorist use of a motor vehicle.September 11 also prompted an industry-wide debate about security and financial returns. Several smaller but well-rated reinsurers ceased trading in the immediate aftermath of the terrorist activity in the US. At the same time, insurers began to demand the highest levels of security for their long-tail reinsurance protections including motor. Rating agencies re-appraised and downgraded several companies in light of the changed economic environment and questioned their capability to handle long-term latent claim exposures. The few remaining reinsurers providing unlimited capacity combined with strong financial security found themselves to be in great demand. The new capacity that poured into the Bermudian market had little interest in non-US liability business and absolutely no interest in unlimited. The more general retrocession market had collapsed and with only one company offering unlimited retrocession capacity, other reinsurers began to withdraw or question their continued commitment to the unlimited market.Shareholders demanded better results from reinsurers, seeking returns commensurate with the risks they were taking. Stock analysts were perceived to be penalising those companies that ran unlimited exposures on their balance sheets, and management of reinsurers started questioning whether an enhanced rating from the analysts would be better than continuing with the unlimited sector.The scene was set for reinsurers to take the next steps in the unlimited story.

Where are we now?By the end of 2001, reinsurers had introduced terrorism exclusions or limited exposure to the statutory minimum where exclusion was not possible, for example in motor. The move met with little resistance, the intention being well understood by all parties. The situation was facilitated somewhat by the availability of a secondary market for terrorism-specific covers.Encouraged by this success, the obvious hard market conditions and the lack of viable alternatives, reinsurers moved to introduce restrictions in other areas of unlimited exposure. For 2003, motor third party property damage in the UK was restricted to £20m per vehicle, often with an event cap of £60m. In other parts of Europe, limits of ¤50m are being imposed. In areas where there are legal requirements for unlimited, reinsurers are attempting to encourage debate between the insurance industry and government in order to develop a strategy for the orderly progression to a fully limited marketplace.The current problem for reinsurers (and, indirectly, for insurers) in the UK is that the authorities do not seem to be interested in debating the issue. Evidently it is a sensitive political issue in a consumer-driven society - politicians see no votes in assisting overseas reinsurers. Regulators also appear to be unwilling to enter the debate and advise how they would view the accounts of insurance companies full of unreinsured unlimited exposures. Added to this, the generally poor public perception of the insurance industry in the UK would not be enhanced by the withdrawal of cover that the public are used to having the benefit of, albeit often unknowingly. Reinsurers, however, with no legal obligation to provide the cover and little apparent concern about public image may just walk away. Insurers could find themselves "trapped between a rock and a hard place".

What happens next?

The ultimate step? While there are some reinsurers willing to continue providing unlimited cover for the statutory unlimited risk (perhaps with the exclusion of terrorism exposures), it is the large European reinsurers that are leading the move towards eradicating unlimited business. They appear to be little concerned with the great strategic advantage they would seem to have over their competitors that cannot or will not participate in the unlimited market. Will the exit strategy pay dividends for these reinsurers by increasing analysts' and shareholders' confidence in their operations, or are there other fundamental concerns? Would the theoretically improved security offered after withdrawal further increase the already high demand from the insurance industry, or will new capacity enter the limited market and cause a soft cycle? Regardless of these concerns, reinsurers look set to try to move from what they see as the penultimate to the ultimate phase fairly soon. The start of 2006 has been suggested as one possible changeover date. This would appear to give plenty of lead-in time, but there are concerns with Government policy here where changes are unlikely to happen so rapidly. Decisions to be made and options available If, or when, unlimited reinsurance disappears, what should an insured be doing? This depends on whether legislation has been changed. If the law is changed then insurers will have to make an assessment of realistic, worst-case loss scenarios and convince the authorities that they are appropriate, in order to determine how much cover the market should be providing. Hazardous goods vehicles always spring to mind in these discussions, as does the coach carrying the Real Madrid football team. It is not difficult to arrive at very large numbers, very quickly, in any theoretical disaster scenario.Developing a target loss scenario and setting a legal limit is one thing. Determining whether the reinsurance market will offer such capacity is another. At this time, reinsurers are unwilling to state the size of capacity that they might make available for the top end of motor programmes. It seems unlikely that we will be talking about limits much beyond £100m, not least because of the capital implications that go with providing such capacity. Further, there is the issue of pricing. A limited cover always seems to attract a minimum price. Will insurers be able to pass these costs on to their policyholders? Will the average driver in the car want to pay for £100m? Would they be just as happy with £25m? And then what happens to uninsured losses?If the law is not altered and insurers find themselves running unlimited exposures on their own balance sheets, they will still need to determine their own loss scenarios in order to optimise reinsurance purchasing. A limited market by practice will entice new reinsurance players to take part. Willis has already been active in placing specific covers in the terrorism field and is exploring options within the third party property damage area. We expect further options would be available if bodily injury is limited.

ConclusionWe do not believe that any final decision on unlimited has been taken, beyond the theoretical position that sooner or later the practice will require reinsurers' attention, so we expect to have further debate on the subject. For example, one scenario seemingly dismissed at present is the pricing alternative. In this context, one could envisage that reinsurers might feel unlimited could still be a viable option if they could obtain prices that adequately compensate them for the loss scenarios they see as possible. This debate could have a double benefit. It might secure the continued existence of unlimited cover, while the pricing issue might draw government attention to the matter.Another discussion that could take place would be about the whole basis of compensation of bodily injury claimants. Is a negligence-based system better than a no-fault compensation scheme? Should there be caps on individual amounts of compensation, as in the Nordic area? Currently, it seems that reinsurers are little concerned about their relationships with insurers and are much more focussed on what the analysts and shareholders are saying about them and the performance they are demanding of them, though perhaps this is not entirely unexpected after a sequence of poor results and some very major individual losses. There are many issues still to be resolved. The current atmosphere appears to be that reinsurers seem determined to take the 'final step' this time - but even a week is proverbially a long time in politics. It remains to be seen whether it will really happen or whether we will still be talking about the issue in another ten or twenty years' time.By Mark ColeMark Cole is an Executive Director at Willis Re.