Alan Williamson argues that reinsurers should look closely at direct carriers' risk differentiation techniques to improve standards of risk management and ultimately reduce loss costs
Risk management is nothing new. Risk managers are now commonplace in large organisations and no one doubts the value of risk management in reducing the cost of risk. The insurance industry certainly benefits from this, but it has been slow to incentivise the greater use of risk management.
While the industry appears to be keen to encourage the management of risk, the traditional approach is to wait until there is an improvement in the claims experience before considering any reduction in premium.
However, an insured might reasonably point out that well-planned investment in risk management delivers an improved insurable risk. They will, therefore, want insurers to recognise this in terms of the premium, or terms and conditions, otherwise there is little incentive for the company to make that investment in the first place.
In other words, the industry could do more to clearly differentiate between a good risk and a bad risk, and to provide an incentive to manage risk.
Risk management is being sold on the back of best practice, rather than the potential for competitive advantage.
The reinsurance markets can influence and help improve this situation by applying a sharper focus to direct carriers' risk differentiation techniques.
If reinsurers were to give a differentiated rate to an insurer that has (more than) adequate processes and procedures to differentiate the good risk from the bad risk, then the knock-on effect would be that the insurer would get a differentiated deal as, in turn, would the client. Thus, everyone benefits from the improved management of risk.
What should reinsurers expect of their cedants? Reinsurers are looking for peace of mind, and so they should be looking at what happens when an underwriter actually rates a risk. Reinsurers should be ensuring that an underwriter is carrying out adequate due diligence and is scientifically evaluating a risk. They will also want to ensure that adequate pricing policies and technical underwriting standards are in place, and that the people authorised to write the business have a high degree of expertise and experience.
Ultimately, reinsurers should be saying to their cedants:
- we want to fully understand how you rate and underwrite risks;
- we want tangible evidence of the risk management standards that you seek before you write risks; and
- we want tangible evidence of the fact that your people are qualified to understand the subject of risk and not just the subject of insurance.
Rating and underwriting risks
Reinsurers need to be able to trust that their insurers' underwriting standards, pricing processes, systems and protocols are adequately robust. Corporate governance is clearly part of this process.
In the UK under Turnbull, for example, one would expect that a UK-listed insurer would have carried out adequate assessment of strategic risk and developed a controls framework. The quality of this work will give a reinsurer an indication and appreciation of the carrier's attitude to managing risk.
Fully understanding and assessing an insurer's commitment to corporate governance is part of the due diligence process. This is especially true when it comes to long-tail liability risks, where understanding strategic risk is about taking all reasonable, practical, proactive steps to prevent the company from going out of business. If you are reinsuring an insurer and there are long-term risks and long-tail claims involved, you want to know that the insurer is going to be in business for the foreseeable future.
Risk management standards
Risk management is not merely compliance, and it is vital that insurers encourage insureds to move beyond compliance into true management of risk.
Health and safety measures are often driven simply by compliance, but being compliant does not necessarily protect you against accidents.
This is especially true of liability risks. For example, 88% of accidents are caused by human error. If a reinsurer is really interested in risk management, they will be interested in what the underwriter is doing about the human behaviour aspect of that risk that they are about to write, because the 'soft issues' often drive claims.
Unfortunately, what often happens in the insurance market is that a health and safety audit is attached to an underwriting submission and the underwriter prices based on information provided. But what is the insured actually doing to stop claims? What about techniques such as behavioural risk improvement?
A more effective alternative would be to present to underwriters a performance-related plan designed to drive down incidents, attritional losses and high frequency claims experience. This approach focuses on peer pressure, supervision, communication and a deep understanding of the risk issues at hand.
A challenge for reinsurers is to understand what is driving claims in their areas of interest, and what needs to be done to reduce these claims.
This involves encouraging carrier movement from a claims-driven underwriting response to include a quality of information aspect that addresses questions about the attitude and the culture of the company. A health and safety audit and loss estimations are clearly not enough.
Building the picture
Improving the quality of information provided to underwriters requires building a scientific evaluation of the risk. Without this, all you have is a standard insurance submission, with basic information and no real opportunity to seek differentiation.
Elements that need to be looked at when evaluating risk can include:
- property loss control standards;
- liability exposures;
- employer's liability assessments;
- stress risk exposure;
- fleet risk management standards;
- business interruption aspects and key dependencies;
- D&O preventions;
- retention analysis and history; and
- claims analysis and history.
The aim of using such risk management techniques is to improve the quality of the risk profile of the insured, with the expectation that this will be recognised by the underwriter, for example through reduction in premium, funding of risk management premium, conditional risk management work on placement, claims rates incentives, pro rata recognition of risk management work, or incentives through adjusted limits and retention levels.
This is the kind of dynamism that is needed from within the industry to effect change. But from a reinsurance perspective, it is not easily applied. And reinsurers should quite rightly question the extent to which the underwriter technically understands the subject of risk, and may question the level of allowance that the underwriter has to adjust the price. Hence the importance of the competence and experience of the people involved.
Having the right people is a key issue. The Financial Services Authority will clearly have an impact on the quality and technical competence of people in the UK insurance and reinsurance industry, because it is reasonable to expect that anyone giving professional advice should have adequate training, knowledge and practical experience.
One of the principal reasons for the failure of risk management to deliver consistent results is that there is not enough understanding of the relationship between managing insurable risk and purchasing insurance, and transparency of return on investment for risk management efforts. As a result, we have many businesses that invest in risk management but are failing to get any transparent recognition from insurers.
There are many factors behind the under-incentivisation of risk management within the insurance industry. Underwriters may claim that they do not receive the risk information early enough to underwrite it accurately, while insureds regularly complain that their risk management investments are not being recognised.
What we need is the ability to price risk with, and without, risk management.
This allows for differentiated deals and provides incentivisation for managing risk. If a business is able to buy insurance that has a price with risk management and a price without, a degree of transparency is introduced into the process. But an underwriter needs flexibility to offer that price, and needs a reinsurer who is comfortable with that flexibility.
Risk management advisers can have a positive impact on the underwriting process, pricing and procedure. The relevance to the reinsurance market is that they can be used to build a picture of standards within an insurer.
For example, Marsh's Risk Consulting Practice has carried out reviews for insurers looking at their underwriting standards and their ability to measure risk. These would also involve a review of the competence of the people, how positive and negative risk management factors have an impact on loss estimation, and how losses are actually estimated in the first place.
Such an independent review can provide an insurer with tangible evidence to present to the reinsurance market, and hopefully help them to differentiate their own risk profile.
Reinsurers can play an important role pre-loss, by helping to create an environment flexible enough for differentiated deals. But this requires a high degree of trust between insurers and reinsurers, even perhaps a leap of faith.
There has been an ongoing debate about whether underwriting is an art form or a science. Flexibility in underwriting comes from acknowledging that both art and science are required, and what the industry needs is people that have the dynamism and experience to treat it as an art form, but who can back this up with technical expertise and scientific knowledge.
In other words, people who have earned the right to become flexible through experience and technical knowledge. This can provide the differentiated deals that reward risk management, while at the same time providing peace of mind to reinsurers.