Written by Steyn McDowall, Indwe Executive Director: Business & Specialist Insurance
Insurance, at its essence, is a source of finance to pay for losses, when they occur. In theory, the contributions of the many pay for the losses of the few. The risk transfer to an insurer is subject to conditions but there is the advantage of stability in settled law and practice. For larger organisations, insurance tends to be more a “loss-smoothing” device rather than risk transfer, because claims are likely to be reflected in increased premiums. It is most obviously a case of “rand swapping” in high frequency/low severity risks.
Insurance companies emphasise “security”, but for corporate customers uncertainties remain, such as under insurance, over insurance, overlapping covers, incorrect assessment of exposure, insurer solvency, and even policy wording being negotiated after commencement of cover.
There are other negative aspects to insurance provisions:
- poor quality of service
- cost of premiums may be related more to insurers overall portfolio than to insured’s loss experience
- insurer’s “knee-jerk” reactions to market-wide or insurer-specific claims problems, resulting in volatility of premiums and/or rapid withdrawals of cover (e.g. asbestosis, professional indemnity, terrorism, Directors & Officers, infectious diseases)
- premium determinations being heavily influenced by blanket reinsurer needs
- the heavy reliance on historical data for setting premium rates and little or no recognition of the value of proactive risk management
- traditionally slow to offer new covers
- primary insurers’ limited capacity
- insurer takeovers and mergers improving individual insurance company capacity but leading to shrinking market choices
- the attractiveness of personal lines business to insurers over commercial business
- costs arising out of insurers operating inefficiencies built into premiums
- hidden costs such as broker over-riding commissions
Reinsurers adopting a hands-on approach
There is no question that globally the financial services industry, including the reinsurance sector, is being forced to tighten its belt. In the wake of the financial crisis and the current impact of the COVID-19 pandemic, many reinsurers’ ratings have been downgraded and the cost of stable security (A – upwards) is considerable.
Quite simply, reinsurance is one of those markets in which a thorough understanding of the client (insurer) and its markets is essential. In fact, as the financial crisis bites ever deeper, reinsurers are becoming more involved in the management of risk transfer than they ever have been before, concerning themselves with areas where they were never previously involved. So, not only is it now a lot harder to find reinsurance capacity in the local market, it comes with an increased administrative burden. Reinsurers are adopting a far more hands-on approach: requesting a constant flow of information on a monthly or, at the very least, quarterly basis so that they can have a closer understanding of how risks are being managed.
When creating or reviewing a current strategy, an organisation is faced with several options, these include:
- Risk transfer: Formal/conventional insurance programmes are still the most common form of transferring the risks faced by organisations locally, where the outsourcing of the funding of loss is direct to an insurance provider.
- Risk retention: This typically consists of a strong risk management/risk control programme with internal provisions to cater for loss.
- Risk financing (ART): Organisations with advanced risk management/risk control programmes can successfully mitigate risk. An understanding of the frequency and severity of the risks involved enable decision makers to retain certain risk and only transfer catastrophic risk. These programmes include specific structures to manage the impact of loss, for example a balance of loss layering and transfer, depending on cost.
For the Alternative Risk Transfer (ART) market, this translates to higher risk pricing and improved underwriting process and information management, resulting in an increased focus on risk management and risk financing by organisations. In the past few years, the South African insurance market has generally experienced poor loss ratios in corporate property and motor. In addition, last year reinsurers imposed the price increases of insurers, driving a hardening of the insurance market both globally and locally. The current impact of the COVID-19 pandemic has put further strain on the market. All indications are that the hardening market will continue well into the near future. This has resulted in rates being increased substantially, while corporate property and liability portfolios remain under pressure, with continuing large losses affecting underwriting performance. This means that reinsurers will continue to seek higher risk prices going forward and there will be downward pressure on the treaty terms enjoyed by insurers in this market.
Some organisations prefer the strategy of transferring as much risk as possible, to try and keep retention (excesses and deductibles) as low as possible, spending the minimum on risk mitigation. Insurers see this as being reckless and prefer to decline the risk.
Advancing alternative risk financing strategies
Insurance per se is not the best method of maximising shareholder value. Consider the argument that insurance is not an effective risk management control and that there is no guarantee the policy will respond and the claim be paid. With insurance, there is a potential for delay in restoring assets and for disputes over claims to be resolved (which may lead to delayed claim payments). On top of premiums, an insured will incur management costs of administering and reviewing its insurance portfolio. There are also likely to be fees or commissions to brokers and advisers.
It is debatable whether an organisation’s share price will recover because of an insurance payout, the correlation is far more likely where solid crisis and risk management strategies are in place and are constantly tested and reviewed.
Traditional insurance markets are focused on hazards and perils, this may have led to industry stagnation and a serious lack of innovation, forcing some organisations to take an introspective view and advance alternative risk financing strategies.
Keep it simple, consistent and transparent
Organisations are moving away from the typical brick and mortar cover and are far more concerned with the impact of risks such as cyber-attacks, reputational damage, and brand protection. Organisational change is leaving organisations open to new risk exposures. Re-engineering due to factors like the impact of COVID-19, acquisitions, and new capital projects, all contribute to the risks faced daily by organisations.
So, what is the solution?
My view is that organisations should follow a zero-based risk strategy every three to five years or, at the very least, when there is a cyclical market change as is currently the case. Zero-based insurance and risk management programmes promote ownership throughout the organisation, empowering management to make decisions wherever practical. A successful zero-based programme looks to address difficult risk issues with a “keep it simple, consistent and transparent” approach, taking emotion out of the process.
The strategy considers the state of the insurance markets in terms of minimum risk standards, underwriting approach and pricing for each class of business. These outcomes will dictate the recommended approach, as would any changes in the short to medium term business strategy of the organisation, which is influenced by many different internal and external factors. In the short to medium term, the organisation must ensure alignment of their insurance programme to the organisations risk profile and exposures. This will go a long way to optimising the cost of risk, to support the future business strategy of the organisation.
Consideration must be given to the organisations propensity to take risk, their risk appetite (How have current commercial pressures shaped risk appetite?) and tolerance. Equally, the accuracy of risk information, including a review of target risks, high risk exposure areas and anticipated changes in risk exposures for forthcoming periods of insurance, is critical to understand. The organisations broking strategy should be in place and a detailed review conducted on a quarterly basis. Policy wordings must be reviewed and analysed annually to effectively consider changes based on market trends, which may take the form of the introduction of restricted cover and conditions.
Whichever side of the argument you hold, there is no doubt that the shortage of capacity worldwide (and the increased cost of capacity when it can be found) will force larger corporates to self-insure more, which augurs well for the alternative risk transfer market in these uncertain times.