David Doe gives a personal view of today's market and economic pressures
The professional liability underwriting cycle is still in a robust mode with rates remaining high and the dreaded return of hyper competition not evident. Whilst the green shoots of eccentric competition can be witnessed on the fringes, for the most part underwriting discipline remains. This utopic state of affairs will of course not continue unabated.
It was with the bursting of the technology bubble and the ensuing geopolitical uncertainties that the world's central bankers embarked on aggressive rate cutting. In an effort to avoid recession and stimulate lacklustre economies, central banks led by the US's Federal Reserve consecutively cut interest rates an unprecedented 13 times. Given such skeletal base rates, money has never been so cheap. Buoyed up by easy money the consumer has engaged in a spending spree that has indeed helped to invigorate stagnant economies.
The by-product of this massaging of economies has been the return, albeit at a glacial pace, of rising inflation. Since this is the bete noire of central bankers, it has now resulted in the need for fiscal tightening and ergo the slow raising of interest rates. If, as expected, rates continue to rise then capital might be further enticed back to the insurance and reinsurance industry.
This is the conventional picture. The insurance cycle and economics in general move in a steady pattern that can be almost tracked, depending on the prevailing conditions of the insurance and financial markets. But conventional wisdom may not be a particularly good guide for the current market, which is much more vulnerable and delicate than many analysts and the abundance of inexperienced underwriters might appreciate.
The crude fact is that the past period of undisciplined cash flow underwriting was far longer than many would be prepared to admit. A period of underwriting dyslexia went on unpunished probably for a decade, pumped up by the most hedonistic investment returns of a spectacular bull run starting in 1982, and only really coming to an end with the collapse of world stock markets in early 2000 (and lasting a full three years thereafter).
Since the return to reality, starting in 2000, three huge events combined to hit the insurance industry. Firstly, the stock market collapse itself impacted insurers' investment funds - particularly UK and European insurers that had substantial exposures in their investment portfolios to equities.
This damage to balance sheets hit insurers' (and more so reinsurers') capacity to write business with their credit ratings and liquidity ratios negatively affected.
Secondly, the stock market collapse also led directly to the corporate unravelling of various misdeeds of major accounting firms and investment banks in unison with company executives who engaged in 'creative' accounting in an effort to keep corporate earnings attractive for investors. This outrageous practice had become endemic not only in corporate America but in Europe as well. These shenanigans have now led to a myriad of law suits against no end of involved professionals and this in turn has created a veritable black hole of directors' and officers', errors and omissions and financial institution insurance related claims. The final quantum on these claims is yet to be known, and indeed will likely never be known, but will amount to catastrophic multiple billions of dollars of paid claims.
Thirdly, of course, was the largest ever insured loss of the 11 September 2001 terrorist attacks. This appalling event caused massive losses to the industry but in fact represented a smaller aggregate loss than the combined loss of insurance industry capital during the three year stock market decline.
All three individual events have produced enormous repercussions. Combined, they have been, to use a euphemism, very difficult for the insurance market to absorb, with the damage being difficult to hide as demonstrated by the unprecedented number of recent insurer credit rating downgrades. But the upside of these events has been the seismic shift from a soft to a hard market, with substantial rate increases, improvement in policy language terms and conditions and a return to disciplined underwriting - in short, an ability to really make money from profitable underwriting hopefully without any reliance upon investment income.
However, whilst this attractive scenario will seduce many a professional liability underwriter into feeling contented about the prospect of stellar underwriting results (and the ensuing rich personal profit commission rewards), many such underwriters would be best advised to cool their ardour and take a long-term view.
It comes down to what qualifies an underwriter as being 'good'. How do we define a successful underwriter? That is easy - a good professional liability underwriter is one who is a profitable underwriter. But how do we measure profit, remembering that professional liability business has a long-term developing tail? All will have a different view, but in order to discern an individual's record a four year track record is probably best. However, in order to apply this strictly, such years should be fully mature years of account. Again, this is open to polemic debate but, in my personal view, a fully closed professional liability year takes on average five to six years and, to be conservative, probably longer. Hence the view that in order to really judge a professional liability underwriter's acumen, over say four fully 'closed' years of account, an underwriter requires tangible unbroken figures of ideally, 10 years of results in order that four fully mature years can be accurately appraised.
Therein lays a considerable nexus issue when carrying out any determination of our current cadre of professional liability underwriters. For I would wager that the amount of individuals who could produce such an historical record of personal underwriting results (let alone good results) would be small in number, and those that could would often show highly unappetising figures. Those few that can genuinely produce good figures and demonstrate profitable underwriting on four fully closed years of accounts are the real luminary figures of an often brutal market.
And it is also a market that allows less talented individuals to often evade the consequences of past underwriting failures by the camouflage of corporate change and the passage of time, all of which can act in unison to 'cover the tracks' of an individual's past underwriting misadventures.
The industry's often lax censure of such people does allow for a surprising number of individuals to masquerade as underwriters of stature when in fact they are no more than professional poseurs. Such people rarely learn from their own mistakes, often re-offending, and can help lengthen or even bring about soft cycles of undisciplined underwriting. Ultimately it is the fault of management's due diligence that allows for the employment (and re-employment) of such individuals, but such fundamental failure of management is common.
The one thing that can concentrate the mind of even the loftiest of management is the bottom line. When results turn red, management becomes reactionary and given the tendency, especially on professional liability business, that bad years tend to get worse not better, the reaction usually means heads rolling and the closure of underwriting units. This is, of course, a bit like closing the stable door after the horse has bolted because, going back to the long-tail nature of the business, the damage has well and truly already been done. It is better for management to get its selection of underwriting talent (and business plan) correct in the first place than to discover three or four years 'in' that it is not happy with the way things are going, because it will be running the results off for another five or six years at least after the final year of underwriting.
The underlying reason that in the recent past, say the last decade or so, certain professional liability underwriters got away with ultimately very poor underwriting was a combination of two things. Firstly, the past decade, (indeed prior to 2000 the past 18 years) had seen a period of formidable investment returns. Secondly, the tail on professional liability business is always longer than people expect. This combination of strong investment income coupled with a long tail acted as a good cover for a period of pretty awful underwriting. The ultimate providers of capital (which was in abundance due to the booming returns from investments in the financial markets) were content to just roll over the premium income as an investment play, ie underwriters became cash generators for the 'money men'.
A correction was bound to occur to such an unhealthy business paradigm.
This era of serious 'cash flow' underwriting came to an abrupt end with the dramatic events of 9/11 and the stock-market crash. All of a sudden the risk business of insurance was hit with a huge dose of reality. The immediate consequence has been a return to disciplined underwriting, fuelled by the basic economics of supply and demand, in that a lack of capacity has raised rates and created a harder market environment
Opportunities for Lloyd's?
Can Lloyd's capitalise on the current and future market or will we see grey days at Lloyd's?
Oscar Wilde once said he could resist anything but temptation. The same could be said of insurers. One of the prime drivers of the insurance industry is discipline or rather indiscipline. Underwriters are more often than not quite good at their job, ie that of risk selection. But it is often the vagaries of their management that dictate from above the final underwriting policy. This can be where the problems start as management wants to see not only profits but use of capacity. However, such is the risk business that often withdrawing from certain business, due to pricing declines or broadening of coverage, is not only advisable but vital. It should be the frontline underwriters who decide policy and not the executive management.
Although Lloyd's has traditionally avoided these problems, with underwriters actually setting business policy, today's Lloyd's with its larger syndicates is slipping into the trap of management from afar. Lloyd's needs to watch its back! Although the franchise board is here to police the market, a great many market practitioners fear that the switch from the now out of vogue smaller syndicates to the more mammoth operations is cause for much concern. We have heard much about the need for great efficiency and strong management at Lloyd's, but the venerable leadership of the market seem almost obsessed by size. References to 'critical mass', 'economies of scale' and the need for 'quantum' have become common, while a leading underwriter recently told me that any new start-up syndicate would really need "at least £100m".
All of these buzz words and the enormity of the size of capital for new syndicates is frankly very concerning. The Lloyd's market is what it is, a market of different businesses, which should and must see the start of new syndicates on a continuous basis. It should be possible for talented underwriters to escape the shackles of the large ponderous insurers to start new dynamic syndicates. But the current developing regime at Lloyd's is in danger of stamping out such entrepreneurial spirit by the heavy emphasis on size.
A group of talented underwriters managing their own syndicates and producing underwriting profit is the key goal. Those syndicates that produce profit will succeed, those that don't will not. But Lloyd's faces the real danger that the emphasis on bigger syndicates will actually hamper the chances of outstanding profits. As large syndicates divisionalise segments of the underwriting, the profit centres will be diluted by poorer performing areas of a syndicate account. The end result will be that any overall profit is reduced. In such circumstances, Lloyd's overall performance could well become ever more mediocre.
The really exciting thing about Lloyd's is its ability to move quickly, with underwriters able to make decisions on the spot. But the small specialist boutique syndicate is in real danger of extinction, being more likely now to be just a section of a larger syndicate. Where individualism is lost in a sea of uniformity, the individual tends not to stand out and entrepreneurial risk taking, ie underwriting flair, is ironed out, no doubt much to the satisfaction of the army of market compliance officers and regulators. But Lloyd's is a risk taking market, that has evolved over 300 years on a diet of who dares wins. In the risk business, there is no reward without risk and if this culture is tampered with then the very fabric of Lloyd's could be impacted.
I am opposed to Lloyd's becoming some sort of grey place of endless form filling and bureaucracy. That just isn't Lloyd's. If Lloyd's becomes the effective equivalent of just another large European insurance company playing a grey game, with grey people on grey days, that would be more than just a shame. It could be disastrous.
Buy now, pay later
Today's cheap money and growing debt do not augur well for the future.
The mid-1990s spawned a marvellously mercurial economic theory, it was the famous not to be forgotten, new business paradigm. This theory was that, driven by new technology, the major leading western nations had reached such a level of efficiency that they would deliver consistent levels of economic growth.
I vividly recall hearing about the 'biscuit theory': 20 years ago your local supermarket had 10 different types of biscuits to choose from, 10 years ago there were 20, and now when you visit the supermarket there are 40 different types of biscuits, this being an example of growth and demand and hence the new business paradigm in action. That smart Ivy League Harvard graduate types writing economic essays could enthuse such views is perfectly excusable as the product of young highly active minds. But that it could actually seep into everybody's everyday psyche, courtesy of the mass media and no end of investment advisors gushing 'buy now or lose out', is more than regrettable, it is almost scandalous.
The fact is of course that, buoyed by the false optimism of a mantra based on completely unfounded theory and, let's face it, pure greed, everyone was to be impacted by its failure. This illusion of perpetual growth and stability was shattered with the bursting of the stock-market 'tech' bubble in early 2000 and the calamitous terrorist attack of September 11 2001.
These two huge historic events, almost on a par with the Wall Street crash of 1927 and the Pearl Harbour attack of 1941, occurred just 18 months apart.
There are significant differences when applying comparisons. The Wall Street crash led to not just recession but a worldwide depression promptly unemploying tens of millions across the developed world. Although the stock market crash of 2000 and the following three years of falls of all of the major western economies actually eroded significantly much more wealth than that of the 1927 crash, there was a higher level of corporate and personal wealth than in 1927 and hence more ability, however painful, to absorb the losses without mass failure of industry and services. Equally, although in terms of numbers killed the 11 September attacks were actually worse than Pearl Harbour, the effect of the Pearl Harbour attack was much more dramatic with the US entry into World War II after Hitler affecting the Tripartite Axis pack between Germany, Italy and Japan declared war on the US. This decision actually saved Britain (and her Commonwealth) from continued fighting of all three Axis nations on her own. Such a move ultimately saved all of Europe if not the world from tyranny. The September 11 attacks, whilst a shattering blow to confidence, did not have such instantly dramatic geopolitical repercussions.
However, for all the very instant dynamic effects of the Wall Street crash and Pearl Harbour, we should not underestimate the combined severity of the three year stock market falls of 2000-2003 and the brutal arrival of mass terrorism of 2001 and beyond. They have both caused much damage and their after-effects will be felt for an enormously long time. Indeed the hangover from both events will have material effects for decades to come.
Because of this 'double whammy' of bad news, western nations' central banks, fearing a deep recession, took strong fiscal action with an unprecedented period of interest rate cuts with a view to regaining economic growth.
In crude terms, increasing the availability of 'cheap' money boosts economic activity. Whilst this policy has undoubtedly worked well in certainly keeping a deep recession at bay, it has produced its own long term significant problems.
There can be no doubt that the consumer, through various guises, has held together the momentum of economic growth via a continuous spending spree. But such momentum without wider economic expansion eventually flounders for without significant real rises in gross domestic product, ie earnings and growth, the consumer will eventually become overburdened with debt.
A classic example of this is the massive over-heating of the housing market both in the US and the UK. Such availability of capital courtesy of low interest rates has helped to engineer a period of incredible house price inflation. Millions of home owners have been enriched by this mammoth period of rises in property values but this has led to a classic and highly unsustainable bubble. As many consumers have witnessed alarming falls in returns, and even erosion of personal investments such as endowments, pensions, equity funds and savings accounts, they have often found investment redemption with usually their main asset, ie the family home, rising in value. Many have further added to this developing bubble by the purchase of second properties as a pure investment.
However, the dangers of such over-consumption are all too obvious. There is no continued ability for the consumer en masse to carry on with ever increasing levels of borrowing. However 'cheap' the availability of money, there is a finite hiatus point at which personal earnings can no longer cope with the level of accumulated debt. The simple fact is that any borrowing has to be paid back and there is is the danger that large and long term home loans may not be paid off as investment instruments fail to produce the growth needed to pay off the capital debt.
As with physics, there is balance in economics, with one force being equal to another. The by-products of cheap money are low interest rate levels and low inflation. Given such a low beta for investment returns, whilst capital is easy to acquire it is significantly more difficult to pay off. The result is a further developing bubble, this time of a significant gap between accumulated debt and long term savings. This 'savings gap' will affect people's ability to pay off mortgages and pay for retirement.
It is an enormous investment timebomb that will not fully explode until maybe the next 20 years.
The conclusion here is not a positive one. The bull run of 1982-2000 was an outstanding period of investment returns and capital growth, with hedonistic double digit performance. That utopian period has well and truly gone. A period of fiscal discipline is needed as this past over-consumption is corrected. The omens are not good, although certainly not so bad as to indicate any stiff recession or depression.
People must forget the past stellar investment returns, the early retirements and the illusion of Olympian wealth creation. The economic peccadillo of the new business paradigm is confined to history. There is no economic new order. What you get paid you must earn, what you borrow must be repaid.
Although they don't currently know it, many people will face a financially harsh future. As they pay off accumulated debts whilst assets currently exceed debts, increasing interest rates and growing inflation will erode the positives. The world economy is frighteningly vulnerable to any significant bursting of the US/UK property bubble.
Overall, these current salad days of underwriting will, or rather should, produce good profits. But the insurance market generally, and especially in the professional liability arena, needs to be far more cautious than some of its current practitioners appear to be. The reality is that this current 'hard' market is a much needed recovery period. The present correction is by no means an invitation to participate in a bonanza of profits, it is in fact still a very fragile situation.
A very potent combination punch of poor developing back years and still anaemic levels of investment income could easily knock out any growing euphoria amongst professional liability underwriters. By all means enjoy the current trading environment, but watch out for the sting in the tail!