The aim of this paper is to summarise the workings of the UK Professional Indemnity insurance market and the hard/soft cycle that has such an influential effect on premium levels. We will also attempt to predict what the future might hold as the market moves inexorably out of its soft phase and into harder times.
Most specialist insurance classes – including Professional Indemnity (PI) – are placed either with Lloyd’s syndicates or with insurance companies operating outside the Lloyd’s environment.
The UK general insurance market as a whole wrote in excess of £40 billion in premium during 2008 covering a wide range of risks, both domestically and internationally. However, the PI market is very much niche in its nature – but just how niche? UK liability premiums for 2007 totalled £3.8 billion, but this included a number of classes of insurance wide of PI, such as Public and Employers’ liability. We estimate that, of the £3.8 billion total, less than £1 billion relates solely to PI insurance. Of this, the largest element is the PI market for solicitors which accounts for around a third of this.
The construction PI sector is thought to represent a smaller proportion of the total premium although exact figures are not available. However, what is clear is that construction PI represents a very small proportion, less than 0.5%, of the UK’s overall premium spend.
Consequently, as specialist PI brokers, the sector of the insurance market with which we work is, necessarily, very narrow.
The Claims Background
Our statistics show that the number of claims and potential claims are increasing year on year – and this trend is also borne out by figures from the Technology and Construction Court. 2008 saw nearly 400 new cases reaching the court, on top of year on year increases previously. Nearly half of the Court’s work now relates to construction and professional negligence claims. We should also remember that the vast majority of claims involving professionals are settled out of court – court cases are really just the tip of the iceberg.
Of equal concern to the increasing claims numbers are their increasing complexity, profile and cost. The longest trial at the TCC last year ran for 109 days and claims have been made for damages of £100m plus against consultants.
Against the back-drop of increasing claim numbers, severity and cost, writing PI business is once again becoming a triumph of hope over expectation.
Premiums Received and Claims Paid
For long-tail classes of insurance such as PI, it is often the case that premiums received are not, of themselves, sufficient to pay claims. Investment income becomes a critical part of the equation particularly when, even now, construction PI claims take an average of five years to reach settlement.
Data from the ABI illustrates just how infrequently insurers make a technical or ‘pure’ underwriting profit on their accounts – only in 4 out of the last 10 years have they been in the black. It is also notable that very often it is the liability insurance market that suffers so significantly from poor levels of profitability
The PI Cycle
The insurance cycle – which affects all sectors to varying degrees at differing times – is the name given to the periodic rise and fall of relative premium levels. As with all markets, the insurance cycle is driven as much by the effects of supply and demand as by the underlying cost of risk.
Catastrophic insurance claims are relatively rare events, but given their size they can make accurate pricing models difficult – too frequent to ignore, too infrequent to model. As large claims are also likely to be complex and involve the vagaries of the legal system, their outcomes are often difficult to interpret.
As a consequence, the forces of supply and demand are often the dominant factors in setting premium levels. Insurers may be prepared to set premium levels below the price of risk in the soft phase against an expectation of generating sufficient income in the hard market to have created an overall profit across the cycle.
However, where individual insurers price risk too low and for too long the consequences can be catastrophic – as we will see later.
In summary, the PI cycle is best seen as something like this:-
If we start in “hard market conditions” with high premiums and the real prospect of good rates of return on the capital invested”, capital enters the insurance market. New entrants to the market look to build up books of business and do so by competing on price. In order to sustain growth (or for more established players to limit lost business) insurers are pressurised to further reduce premiums and/or provide a wider basis of cover.
However, none of this, of course, necessarily reflects any improvement in the underlying risk profile. It is market forces that are driving down premium levels and not necessarily a reduced exposure to claims. Claims still tend to be at the same levels as when premiums were high. As a consequence, claims exceed premiums and insurers start to lose money. Poor economic conditions and reduced investment returns can exacerbate the position.
At this stage we see the mirror image of the cycle. The PI market is now perceived as a poor home for capital and it withdraws relatively quickly to find better investments elsewhere. Reduced capacity (normally provided at this stage by long-term, experienced PI insurers) results in higher prices and reduced policy terms – and so the cycle begins again.
And the Consequences…
Insurers who fail to adequately manage pricing over the insurance cycle – by charging too little for too long – can face catastrophic consequences, as the following two examples indicate.
[a] Case Study – The Independent Collapse
The Independent Insurance Company was founded in 1986 and traded successfully for several years and quickly became the darling of the City. However, all was not well and a failure to adequately reserve for claims led to the Independent’s collapse in 2001 triggering £350m of compensation claims by some half a million policyholders. A subsequent investigation by the Financial Services Authority concluded that the company’s asset base was insufficient to support its business plans.
[b] Case Study – HIH Collapse
The collapse of HIH during 2001 saw the demise of Australia’s second largest insurer. The fundamental problem for HIH was that over a wide range of classes of insurance it failed to charge premiums which could adequately cater for future claims. HIH’s liquidators estimate that it collapsed with debts of £2.1 billion. Company executives have been sentenced to prison terms and thousands of insureds worldwide were affected.
Where are we now – and the future?
The PI market is coming off the back of a prolonged soft market period, which saw many insurers put volume ahead of profit.
And what of the future? It is certain that at some stage the market will enter harder conditions. There is uncertainty as to when the market might harden and by how much. Invariably the deeper and more prolonged the soft market the more pronounced the adjustment will be when it comes.
If the solicitors market is anything to go by, then we could be in for a rough time ahead. With every solicitors practice in the country sharing a common renewal date, the scramble to the 31st October (is it??) is always fraught. This year has been particularly so. Rating increases of between 50 – 100% have not been uncommon, with all practices suffering to some degree. Even those practices as the “less risky” end of the spectrum have seen their rate increase substantially. Where insurers have perceived particular risk factors, even more so, with certain firms being effectively blackballed because of certain practice traits.
Events in insurance, as in life, are powerful and unpredictable. What future events might conspire, individually or collectively, to prompt a return to harder market conditions? The following is a list, by no means exhaustive, of the likely culprits:-
The Credit Crunch
The credit crunch had had (and will continue to have) three adverse effects on the insurance market. First, the cost of capital has increased as its availability becomes scarce. Second, a reduction in the asset base of major insurers as investment losses erode balance sheets – further reducing the capital available to underwrite risks. Third, an increase in credit crunch liability claims as those who have suffered losses (home owners, shareholders etc.) seek to recover from professional advisors, company directors etc.
A combination of increased stock market volatility and reduced interest rates is severely curtailing insurer’s ability to generate investment income.
After two relatively benign years of (insured) natural catastrophes, 2008 saw the second worst year on record for catastrophe claims with in excess of $50bn (£35bn) paid out.
A downturn in the economy hits the insurance industry in two ways: (1) recessions invariably lead to an increase in claims; (2) the contraction in economic activity leads to a reduction in premium income leaving insurers with a reducing pool of money to pay claims.
Our approach will continue by:
a) placing cover with first class markets who are long term players in the construction PI market;
b) looking to charge premiums which reflect the long term cost of risk without prejudicing the position of our clients in the soft market; and
c) offering the guarantee that, absent fraud, all valid claims made will be paid.
And our commitment to proactive risk management will also continue unabated.
There is no doubt that some sectors of the liability insurance market have seen severe corrections. How long consultants in the engineering professions can continue to escape such corrections and how severe they will be when they come is always difficult to predict. There is no doubt that we have hit the bottom of the current soft market and that next year will see rates on the way up. As ever, forewarned is, or should be, forearmed.