Reserving remains more of an art than a science for most primary insurers, and getting it wrong has been a common occurrence in recent history. Bev FitzGerald suggests a claims-based solution.
Following virtually every major incident, the insurance market rushes out reserves. Over the few weeks after the incident these reserves are increased - often very significantly - and even worse, sometimes more than once. By way of example, individual major losses and portfolios of claims following hurricanes such as Katrina and Wilma in the Caribbean and Central America over the past few years have cost significantly more than first estimated. And, in the UK, several of the larger losses arising out of the Buncefield explosion were substantially under-reserved - some by many multiples and several millions of pounds.
These vagaries adversely affect the normal operation of a reinsurer's business. At a claims level, the reinsurer is concerned that the primary insurer might not have full control of the loss in question. As a consequence - and especially now post-9/11 in a more regulated environment - reinsurers have no compunction in instructing their own adjusters or lawyers to protect their interests.
Often, these reserve increases run over two insurance years where, for instance, the effects of a hurricane in the autumn in one year are estimated at a figure which is increased very substantially early on during the following calendar year. This causes problems in the relationship between the direct insurer and the reinsurer where the reinsurance underwriters have calculated their rates for the new calendar year on the previous year's claims history.
At the extreme, such increases can seriously jeopardise the management of capital by reinsurance companies. If a reserve was posted at $100m in the autumn and suddenly increases to $200m early in the next calendar year, the reinsurer may need to alter its investment strategy. Liquidating funds on an urgent basis to meet claims outlays is less economic than carefully forward-planning such cash flow.
Resolving the reserving crisis
So, how can the insurance market address the issue of inadequate reserving? The answer for the more sophisticated sections of the market is to ensure that such claims - both individual major losses and portfolios of losses from "epidemic"-type incidents - are strongly project-managed.
This process is increasingly being led by the more advanced claims managers of the primary insurers. They will set up a team of expert and experienced people to project-manage the incident, either using their own in-house resources or by bringing in external personnel on a short-term, incident-specific basis. This team will represent and protect the insurer's position at the highest level, acting at head office level and also locally in the territory where the incident may have occurred.
All major incidents throw up new technical issues, which have a major impact on how reserves should be set. A key objective for the team will be to communicate advice on these issues clearly and effectively with the insurer's own staff, with the loss adjusters, lawyers and other consultants they may retain and also, in the most sophisticated operations, with their reinsurers.
Fixing the right reserve on major incidents representing thousands of smaller, plus many multi-million pound claims is, of course, not easy. Whilst it may be reasonably straightforward to assess the cost of replacing a hundred thousand panes of glass in a bomb-damaged skyscraper, it is not so easy to judge - and then put a hard figure on - the effects of pressure waves on that structure following the explosion.
At the Buncefield oil storage depot explosion in the UK in 2005, several adjusters were deceived by the fact that the buildings close to the explosion looked fine - and sometimes still had tenants in them working quite satisfactorily. It was only when, often weeks later, the landlords arranged structural surveys that it became clear to those adjusters that the buildings had in fact been seriously compromised by the effects of the explosion.
Or, how do you value the effects of tiny splinters of flying glass on electrical cable throughout the structure? Flooding is also very problematic. Will the building dry out satisfactorily? Will mould take hold following a hurricane or flood? And always, of course, there is that most difficult evaluation of an insured's business interruption loss, including the virtual unknowns of how long the disruption will last and what profits would have been made had the incident not occurred?
Within a project-managed approach to such claims, the team will pre-emptively consider all such possibilities before they become problems and will relay strong technical advice to everyone else involved, including the insurer's loss adjusters. The loss adjusting profession, of course, represents insurers' "eyes and ears" on the ground and are usually on site within hours of a major incident occurring.
Evaluating the reserve is the first, and absolutely critical, decision within the loss adjustment process. Given the importance of the reserve to the primary insurance company and, in turn, their reinsurers, there will be immense pressure on the adjuster to deliver an accurate reserve as rapidly as possible. It is also key to the successful handling of the claim itself. This is because the adjusting company - but also the insurer's project-management team - will want to ensure their professional resources are properly allocated. In particular, the best people need to be dedicated to the most complex and challenging losses.
So, working with their firms of loss adjusters, the insurer's project management team will arrange for the appropriate level of adjusting expertise to work on the various claims on their behalf. They will also help define the supplementary consulting resources - IT specialists, accountants, lawyers, quantity surveyors etc - who will prove valuable on any particular claim.
However, this is by no means the end of the process. In the past, insurers have perhaps relied too unquestioningly on their adjusters' recommendations, especially as regards the reserve. Now though, with robust project-management in place, they will wish to understand exactly how the reserve has been calculated.
This includes business interruption reserves. Specialists within the insurer's project management team will be able to "push back" on the adjusters' recommendations if they are not fully supported and, for instance, do not reflect the scale of the incident, the insured's specific business or the policy coverage in force.
Many of the techniques now in place, particularly with regards to business interruption claims, were initially developed by the direct insurers, working with their reinsurers, in the aftermath of the World Trade Center attacks on 9/11. There, policyholders such as the telecommunications companies, banks and investment houses often had business interruption claims running into hundreds of millions of dollars each.
Within an overall project-managed approach, insurers quickly realised that they had to treat each of these enormous claims as a project in its own right. With advice from their own central team, they hired specialised business interruption adjusters and other consultants, including forensic accountants, trade economists and data managers so they could assess their policyholders' business losses. These experts were invariably reinforced by first-class lawyers who analysed not just the policy coverage but also the "leading edge" issues raised by this incident.
This level of professional capacity ensured not only that the correct reserves were set aside for all of these claims, but also that the cases were dealt with to the highest standards. This undoubtedly led to earlier settlements, which were beneficial for the insurers and, also, their policyholders. As part of the overall approach, insurers came to better understand that their reinsurers were major stakeholders in all the World Trade Center claims. Before 9/11, reinsurers very often received poor-quality information on claims, including reserves, and it was often late.
Apart from the desire to work in partnership with their reinsurers, the more advanced insurers also quickly saw that - from their own pragmatic perspective - if they worked alongside the reinsurers and gave them high-quality, timely information, they were far less likely to experience disputes with them on these often difficult and complex claims. At the very least, such problems might have meant that reinsurers delayed reimbursing the insurer; at worst, the reinsurer might decline to pay out at all.
So, part of the project management team's brief was to ensure that reinsurers were looked after properly. Whilst this often means an initial outlay by the direct insurer for producing reports and presentations for their reinsurers, where this is done well, the insurers benefit both in the short term, in receiving reimbursed funds more quickly than might have been the case, and, long term, by developing stronger commercial links and reinforcing relationships with their reinsurance partners.
Such high-quality project management following claims is, of course, not universal within the industry and is still something to aspire to for even the most advanced insurers. There is no doubt, however, that its application - including the crucial first stage of getting the reserve right - means that claims are settled more quickly and at a lower cost, and that important relationships between insurers and their reinsurers are strengthened, rather than driven into disputes.
As major insured incidents increase in frequency and also become far more complex and expensive, project management of the resultant claims will not just be an optional extra but an essential part of the fabric.
Bev FitzGerald is managing director of FitzGerald Consulting and a past-president of the Chartered Institute of Loss Adjusters.