sigma
No 5/2009 Commercial liability: a challenge for businesses and their insurers
3 Executive summary
5 Introduction: characteristics of liability insurance
9 How much insurance do businesses buy and why?
19 What are the key issues?
26 What can insurers do to keep liability risk insurable?
34 Conclusions Published by: Swiss Reinsurance Company Ltd Economic Research & Consulting P.O. Box 8022 Zurich Switzerland
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Liability is a key risk for corporations … Liability is a key risk for corporations. It typically ranks high in surveys conducted with risk managers. The only insurance risk that ranks higher is business inter- ruption.
… with insurance providing effective The cost of liability risks can vary significantly depending on the size of the protection. company, the industry and the jurisdiction. Liability insurance provides efficient protection against this significant low-frequency, high-severity risk. In the US, the average cost of commercial liability insurance was about 0.2% of revenues in 2008. The average cost of liability insurance is lower in other countries.
Worldwide liability insurance premiums In 2008, businesses spent approximately USD 142bn on liability insurance. were approximately USD 142bn in 2008. This is about 25% of the premiums corporations spent on insurance and slightly less than 9% of the global non-life market premium volume of USD 1 585bn. The developed economies account for roughly 95% of commercial liability premiums. The United States, which is by far the largest market, generates 54% of premiums worldwide. The demand for commercial liability insurance in the US is driven by the size of the economy and the sheer volume of lawsuits that are filed in the country.
Liability insurance is growing faster The amount spent on liability insurance continues to expand rapidly, exceeding than world GDP. the overall growth of world GDP, due to increasing litigation in almost all regions, rising healthcare costs and the overall increase in damages awarded to plaintiffs.
The market is dominated by global and The liability market is dominated by global and national insurers with ample national insurers. capacity, financial strength, expertise in dealing with large and complex claims and international experience needed to support clients relative to their inter- national exposure. As a result, the market is more concentrated than other commercial lines markets.
The unique aspects of liability insurance The following characteristics distinguish liability insurance from other lines: pose challenges for the industry. ̤̤ Liability insurance may cover unknown and unexpected risks. New emerging risks can lead to significant losses that are the result of the interaction of tech- nological innovation and changes in the social and legal environment. ̤̤ The long-tail nature of liability risks results in a higher exposure to inflation, social claims escalation and investment risks. Dynamics in the liability system can create surprise exposures and unexpected changes in the number of claims and claims costs, which were not considered at the time of under- writing the policy. ̤̤ Over the long run, the profitability of liability insurance has been insufficient.
The current profitability is low The industry is currently in a phase of a rapidly decreasing profitability, especially and rapidly declining. in the US. Rates and conditions have been weakening since 2004. Results have been boosted by massive reserves releases and the market has not yet adjusted to the current low-yield environment.
Swiss Re, sigma No 5/2009 3 Executive summary
Insurers must actively maintain control How can insurers and their clients respond to these challenges? Insurance buyers over exposures and profitability. need to include liability risks in an integrated risk management process. Risk assessment and mitigation play an important role in reducing the overall cost of risk and keeping certain risks insurable. Insurers must better understand and monitor the drivers of liability claims costs and then reflect this in the actuarial models. Insurers must also pay closer attention to wording and policy language in order to manage their exposure to liability risks that are rapidly changing. Finally, the underwriting process must at all times remain focused on maintaining control over exposures and underlying profitability.
4 Swiss Re, sigma No 5/2009 Introduction: characteristics of liability insurance
Third party liability insurance is basically Third party liability insurance is usually an ”all-perils” insurance. It protects the an “all-perils” insurance. insured against the legal obligation to pay compensation to third parties for losses or damages for which the insured may be liable.
The insurance of liability risks can be The insurance of liability risks is a relatively new line of business compared to traced back to the early 19th century. marine, fire or life insurance. It has its roots in the industrialisation of the early 19th century. Interestingly, the introduction of third party liability insurance was heavily disputed among scholars and politicians. While the proponents empha- sised the compensation of innocent victims, the opponents perceived the insur- ance of “negligence” as frivolous. Today, the concept of insurance is not contest- ed anymore. Moreover, current tort law and compensation levels would not be possible without a well organised liability insurance system.
Exclusions are used to separate insura- The often broad coverage provided by liability insurance differs from property ble and uninsurable risks or to assign insurance, which is mostly designed on a ”named perils” basis. Property insur- risks to other lines of business. ance provides cover only for losses associated with explicitly defined causes and where claims cannot exceed the value of the insured goods.
Table 1 Differences between liability and property covers
Commercial liability insurance Commercial property insurance Trigger event Usually all events which are not excluded Often confined to named perils Insured risk Refers to liability claims of third parties; Refers to an insured object scope of insurance uncertain Size of a claim Payout restricted by policy limit Payout restricted by policy limit or the value of the insured object Time between premium payment Claims may be discovered with a lag and Usually no lag and quick settlement and claims settlement settlement needs time
Source: Swiss Re Economic Research & Consulting
Compensation of liability claims Liability claims on the other hand, are only restricted by policy limits, which are is only confined by the limits of often set high enough to deal with unexpected events, and exclusions. Because the insurance policy. the trigger events are usually not restricted and because the claim is only defined by the size of the cover and not the value of an insured object, liability claims are much more dependent on changes in the risk landscape.1 While the majority of losses are small high-frequency losses, high-severity events occur. Since large companies tend to buy policies with high deductibles, claims tend to be larger.
1 For a discussion of uncertainty associated with all-perils policies, see Kunreuther, Howard and Pauly, Mark (2004), What You Don’t Know Can Hurt You: Terrorism Losses and All Perils Insurance. Wharton School Discussion Paper, December.
Swiss Re, sigma No 5/2009 5 Introduction: characteristics of liability insurance
Commercial liability claims can The key difference, however, is that in commercial liability the manifestation of a potentially be very large. claim can occur over a longer period of time. The probability of a severe claim is low, but when one occurs, the loss can be very high. As a result, demand arises for large limits, which are often provided by layering umbrella or excess liability policies. Moreover, the potential for accumulation exists, especially in lines such as product and environmental liability (including asbestos), but also in other lines – ie employment practices liability, directors & officers liability and profes- sional indemnity – where judicial rulings may vary considerably.
Case study: product liability case for a small food producer
A glitch in the quality control of a baby food producer resulted in a defective product that was fed to thousands of infants. The defect triggered serious health issues for a number of babies as well as a few deaths. The company was found liable for damages of USD 16m. This was equal to about one quarter of share- holders’ equity or four times the annual profit.
The company’s liability policy provided cover of USD 28m at a premium of USD 98 000, which was equal to about 0.1% of revenues. Hence, the liability policy provided easily affordable cover for a liability event that could have caused severe financial distress for the company.
Scope of this sigma This sigma deals with third-party liability for companies, both large and small. This excludes personal liability for individuals. Also excluded are personal and commercial motor insurance. Workplace injury insurance (eg workers’ compen- sation insurance) is not covered in this sigma due to its fully or predominantly no-fault character and highly regulated nature (eg in the US, UK, and Australia).
Structure of this sigma Chapter 1 of the report deals with the question of why businesses buy liability insurance and how much they buy. The following chapter provides an overview of the commercial lines insurance system. It addresses self-insurance, captives, brokers and the providers of commercial lines insurance. Chapter 3 deals with the changes in the environment, the issue of emerging risks and changes in the legal system. Chapter 4 deals with the issue of how governments and insurers might respond to these challenges. Chapter 5 provides some brief conclusions.
6 Swiss Re, sigma No 5/2009 Types of liability cover
A commercial general liability policy basically provides coverage against le- gal liability exposures of a business unless specifically excluded. Legal defense costs, which can be severe and often need to be borne by the defending party even if a case is won or settled, are typically also covered. The policy may cover “… bodily injury and/or property damage on the premises of a business, when someone is injured as the result of using the product manufactured or distributed by a business, or when someone is injured in the general operation of a business.” Such covers within one policy are usually only provided to small and medium- sized enterprises. For small businesses that are not exposed to specific risks, multi-line contracts including property risks are also provided.
Historically, general liability has been classified into different sub-categories of liability insurance. The broadest scope of specified liability covers exists in the US market. Some of the covers listed below are integrated in the general liability policies in other markets.
Commercial umbrella/excess liability insurance supplements the limits of a corporation’s underlying policies, such as general liability, automobile liability and employers’ liability. The coverage is triggered when the limits of the under- lying insurance have been exhausted. Terms and conditions usually follow the provisions of the underlying primary policies. Less commonly, the cover of the umbrella may be broader than the underlying policies, although it typically does require some self-retention of risks. Higher limits are achieved by adding layers of excess liability on top of the lead umbrella cover.
Environmental impairment liability insurance covers liability and sometimes cleanup costs due to pollution of the environment.
Product liability insurance, typically purchased by manufacturing firms, covers losses which originate from defects in conception, design, manufacture or stor- age of the product, or from improper use by the consumer. Liability is triggered by the defective nature of products, not by their hazardous characteristics.
Product liability is increasingly complemented by special statutory regulations aimed at ensuring product safety, obliging entrepreneurs to take certain meas- ures to guarantee the safety of the products brought into circulation throughout their entire life cycle. Insurance for product recall and product integrity re- imburses the expenses that are incurred by the recall of faulty products, thus reducing the risk of accidents and related product liability claims.
Swiss Re, sigma No 5/2009 7 Professional liability or errors and omissions insurance is the corresponding protection for companies rendering professional services. This cover is typically purchased by accounting, auditing and consulting firms, as well as lawyers, architects, engineers and travel agents. Policies are intended to cover claims for damages based on violations of the duty to exercise care and prudence, or failure to follow state-of-the-art or other generally applicable professional standards and practices. A wide range of customised products exists, for example, for banks and other financial services firms. A special form of professional indemnity is medical malpractice insurance, which is particularly important in the US.
Directors and officers liability insurance covers the consequences of violations of the duty to exercise care on the part of the members of the board of directors, supervisory boards or management of legal entities (such as stock corporations or companies with limited liability). For public companies, this type of policy protects them against certain types of claims from shareholders who suffer in- vestment losses.
Workers’ compensation and employers’ liability insurance2 cover the conse- quences of occupational accidents that occur due to a lack of adequate safe- guards on machines, tanks and vessels, and facilities. Occupational diseases, such as those due to inadequate ergonomic conditions at the workplace are also covered. The compensation of occupational accidents and diseases is usually not dependent on fault and therefore strongly regulated by governments. Systems vary by country or by state in the US. Workers’ compensation is often compulsory and is, to some extent, considered part of the social security system. Depending on the regulation, cover is provided by social security schemes, specialised mutual insurers or the private insurance industry.
Beyond bodily injury, employers are also liable under specific laws (eg anti- discrimination and sexual harassment) for general conduct towards employees, which can be insured through employment practices liability insurance.
2 Workers’ compensation is not covered in this sigma. It is not strictly a liability cover since claims may occur even if the employer is not at fault. It is particularly important in the US and has very specific characteristics.
8 Swiss Re, sigma No 5/2009 How much insurance do businesses buy and why?
Why do businesses buy commercial liability insurance?
Insurability is based on the law Third party liability is one of the most important risks that corporations face. of large numbers. Faulty products, wrongdoings, negligence and the conduct of risky activities can cause harm to third parties who are compensated under the rules of tort law. Tort events are relatively rare; however, the severity can be high, which is why insurance is purchased. Even if there is ultimately no liability, legal defense costs can be significant.
Third party liability ranks just In a recent survey among risk managers, third party liability ranked third after behind damage to reputation damage to reputation and business interruption. Because third party liability is and business interruption. insurable and is normally insured, corporations felt significantly better prepared to cope with these kinds of risks versus non-insurable risks.3
Of insurable risks, third party liability carries the highest cost. Liability risks account for almost Based on data provided by the Risk and Insurance Management Society (RIMS), half of total insurance premiums liability risks accounted for 48% of the total insurance premiums of larger US at US corporations. corporations in 2008, followed by property with 30%, workers’ compensation with 13% and other risks with 9%.4 According to data from MarketStance, US companies spend an average of 2‰ of revenues on liability insurance premiums.
Data from Marsh on the excess liability market provide some further details: ̤̤ The health care, transportation services, construction, utilities, manufacturing and chemicals & pharmaceuticals sectors have the highest cost of excess liability insurance in relation to their revenues. The financial services and trade sectors have the lowest cost of excess liability insurance in relation to revenues due to their high-volume, low-margin business models. ̤̤ The mining, energy, chemicals & pharmaceuticals, utilities, food & agriculture and financial services sectors purchase the largest limits. This may be due to their higher risk profile as well as their larger average size. The government, healthcare, metal products, construction, education and non-profit sectors purchase the lowest average limits. ̤̤ Larger companies profit from economies of scale and spend less on risk transfer in relation to exposure or revenues. Larger companies also tend to retain a higher share of the losses. Due to both effects, larger companies spend considerably less on insurance premiums than smaller companies, despite the fact that they purchase significantly higher limits. ̤̤ Corporations are particularly concerned about US liability risks. European companies with significant North American operations purchased nearly twice as much coverage as companies with no North American operations and paid about 60% more for insurance premiums5. ̤̤ The demand for liability cover is also higher for companies that previously incurred a large loss. In the US, companies that have experienced large losses (> USD 5m) tend to purchase limits that are about 3.5 times higher than those that have not incurred such losses. In Europe, limits are roughly twice as high for companies that have incurred large losses.
3 Aon (2007). Global Risk Management Survey. The 2009 edition revealed a somewhat different ranking which was biased by the economic crisis. 4 Advisen & RIMS (2009), RIMS Benchmark Survey. 5 Marsh (2008). Limits of Liability 2008.
Swiss Re, sigma No 5/2009 9 How much insurance do businesses buy and why?
How much insurance is bought?
Commercial liability insurance is prevalent In 2008, corporations spent USD 142bn worldwide on commercial liability mostly in developed countries. insurance. Their total spend on insurance was approximately USD 600bn. The developed economies alone generate USD 135bn of the world’s commercial liability premiums, The top ten markets – which include China – accounted for 91% of commercial liability premiums in 2008 (see Table 2).6 Premiums in the emerging markets are still comparatively low (USD 7bn).
Table 2 Premiums & GDP (USD billions) Percentage Shares The global commercial Total Liability/ Liability/ liability market, 20087 Rank Liability Non-Life GDP Total Non-Life GDP 1 US 77.2 492.9 14 301 15.7% 0.54% 2 UK 11.7 107.0 2 673 11.0% 0.44% 3 Germany 11.5 132.1 3 684 8.7% 0.31% 4 France 6.9 83.9 2 864 8.3% 0.24% 5 Canada 4.9 40.9 1 517 11.9% 0.32% 6 Italy 4.9 55.1 2 312 8.9% 0.21% 7 Japan 4.7 71.3 4 932 6.6% 0.10% 8 Australia 3.8 21.8 966 17.5% 0.40% 9 Spain 2.7 46.6 1 614 5.8% 0.17% 10 China 1.2 35.3 4 478 3.3% 0.03% Top 10 129 1 052 39 343 11.9% 0.33%
World 142 1 585 60 775 9.0% 0.23%
Sources: National Supervisory Authorities, Oxford Economic Forecasts, Swiss Re Economic Research & Consulting
The United States is the largest The United States is by far the largest market for liability insurance, accounting market for liability insurance. for 54% of gross liability premiums worldwide in 2008. This is due to the size of the economy and the high penetration of liability insurance (0.54% of the country’s GDP). Most other developed countries spend significantly less; liability premiums in the emerging markets were, on average, just 0.04% of GDP. In 2008, businesses spent USD 77.2bn on commercial liability covers in the US. Of this amount, USD 50bn was spent on general liability, including USD 9bn for Errors and Omissions (E&O) and USD 8bn for Directors and Officers (D&O). Businesses spent another USD 13bn on commercial multi-peril policies, USD 11bn for medical malpractice and USD 3bn for product liability covers.
The Canadian and Latin American The Canadian liability market is the second largest in the Americas with premi- markets have been growing strongly. ums of USD 4.9bn. Since 2000, premiums have been growing at an average annual rate of 15%. Latin American markets account for roughly USD 1bn in commercial liability premiums. Penetration is low, but the average growth has been at 14% per year since the beginning of the decade.
6 In many country statistics, liability insurance is not recorded as a separate line of business. This suggests that it is not considered a major line of business in the concerned market. 7 In some countries, the data also includes household liability insurance.
10 Swiss Re, sigma No 5/2009 Liability premiums in the UK were The UK, the world’s second largest market for liability insurance, generated lia- USD 11.7bn in 2008. bility premiums of USD 11.7bn in 2008. Employers’ liability, which primarily covers employment-related accidents and illnesses, accounted for approximately 30% of premium income. Most of this business originated in London. As the principal marketplace for international commercial insurance and reinsurance risks, the London market first and foremost deals with risks outside the UK (ie “home-foreign” business). Lloyd’s and other internationally active insurers generated premium income of approximately USD 7bn from this segment.
Local conditions and historical experience In Continental Europe, the largest markets for liability insurance are Germany, determine which policies are sold in the France, Italy and Spain. Together, they accounted for USD 26bn in gross liability various European markets. premiums in 2008. Local conditions and historical experience determine which policies and covers are available in these markets. In Germany, for example, pro- fessional indemnity is part of the class “financial loss”. This class also includes D&O cover and is written on an occurrence basis. In Italy and France, however, there is a growing trend amongst insurers to provide professional indemnity coverage on a claims-made basis.8 In Spain, the D&O market is still in its early stages and has been growing rapidly. Yet, at this time, it is estimated that no more than 15% of companies buy this type of insurance. Emerging European markets generated an additional USD 2bn in commercial liability premiums in 2008 and have grown at an average rate of 19% since 2000.
Japan and Australia are the Japan and Australia are the largest commercial liability markets in the Asia-Pacific, largest commercial liability with market volumes of USD 4.7bn and USD 3.8bn respectively. At 0.1% of markets in the Asia-Pacific. GDP, the penetration of liability insurance in Japan was much lower compared to other mature economies, despite the inclusion of workers’ compensation in the data. Australia, on the other hand, has a large commercial liability market in terms of penetration (0.40% of GDP) that is rooted in the Anglo Saxon legal framework and also includes workers’ compensation. Australia has mandatory covers for aviation, maritime oil pollution and residential construction, as well as for medical practitioners and property and stock brokers in certain states.
The Chinese market is rapidly growing. Chinese commercial liability premiums were USD 1.2bn in 2008, establishing China as the first emerging economy among the ten largest commercial liability markets worldwide. Growth was very strong at an annual average rate of 22% since 2000, although penetration is still low at 0.03% of GDP. Other emerging markets in Asia grew by an average rate of 10% per year since 2000.
8 France is ahead, however, in creating the appropriate legal framework for that trend to take hold.
Swiss Re, sigma No 5/2009 11 How much insurance do businesses buy and why?
Profitability of the US commercial lines business
Commercial lines insurance profitability The profitability of US commercial liability lines has at times been disastrous, is characterised by strong cycles. with insurers suffering heavy losses due to the liability crisis of the 1980s and the soft market conditions of the late 1990s. In the aftermath of these periods, however, the sector quickly returned to profitability. In fact, the return on capital has been attractive after the liability crisis of the 1980s and during the early 2000s after 11 September 2001. In recent years, however, profitability has once again weakened due to soft market conditions.
What are the reasons for these phases of poor underwriting results? ̤̤ The US liability crisis of the 1980s was mostly the result of losses caused by a change in the legal framework, which held corporates, and therefore their insurers retroactively liable for environmental damage and the huge claims related to asbestos. High (unexpected) inflation in the US over that period also contributed to the losses. ̤̤ The disastrous losses of the second half of the 1990s were the result of sig- nificant under-pricing of the business, coupled with terms and conditions that were too generous. In addition, a number of unfavourable court rulings further contributed to poor underwriting results. ̤̤ There, however, are differences between individual insurers. Even during poor cycle phases, some companies generated profits from their liability business.
One must also consider the long ‘tail’ typically associated with liability lines and the potential for significant shortcomings in underwriting judgement at the time the business is written: ̤̤ Initial estimates for US liability losses from 1997 to 2002 were all too low, resulting in a significant number of companies having to substantially bolster their reserves. ̤̤ The opposite is likely true over more recent years. It is quite likely that 2003– 2006 will end up better than the initial first year estimate. ̤̤ This reflects the typical pattern of reserves cycles. First year estimates of low- premium/high-loss-ratio years underestimate the final claims costs, whilst first year estimates of high-premium/low-loss-ratio years overestimate claims costs. These swings result from the fact that underwriting practices and terms and conditions also fluctuate with the underwriting cycle and their impact on claims is not perfectly captured by reserving models.
Profitability was strong during the hard The following table shows average accident-year combined ratios and their market, but not over the last cycle. standard deviation as indicators of the wide swings in underwriting profitability, which were mostly driven by cyclical rate changes. The higher volatility of liability lines’ results would require higher returns to compensate investors for their risk taking. However, it has historically resulted in an underperformance. According to Conning, the average profitability of general liability over the last two cycles (as measured by ROE) was only 7%, neither matching the average for US indus- tries, which was around 13%, nor the cost of capital, which is estimated to have been between 10% and 12%.
12 Swiss Re, sigma No 5/2009 Table 3 Combined ratios, Commercial Medical Commercial General Accident-year combined ratios of US accident-year 9 auto malpractice multi-peril liability commercial liability lines Standard deviation 13.5% 17.6% 17.1% 23.2% 99–03 115.5% 113.8% 109.1% 127.4% 04–08 95.4% 85.6% 94.9% 87.5% 91–08 108.9% 97.7% 109.5% 108.8%
Sources: Swiss Re Economic Research & Consulting, A.M. Best
US liability prices have been declining US commercial liability rates have been declining since 2004. Rates continue to since 2004. decline in liability lines of business, despite the reduction of industry capital in 2008 after two consecutive years with low catastrophe losses that boosted overall profitability and capitalisation. The competitive environment has led to looser terms and conditions; capacity is more readily available. For the last three years, calendar-year results have benefited from substantial reserves releases, while accident-year loss ratios are rising quickly. Deteriorating underwriting results and the current low interest rate environment make price corrections a necessity in order to restore a sustainable profitability level.
Sensitivity of ROE to investment yield and combined ratio
How does the low investment yield affect profitability? While it is difficult to predict future investment returns and returns on equity, near-term performance can be reviewed under several scenarios. In Figure 1, the current state of the US commercial insurance market balance sheet is evaluated for various investment yields. Based on asset leverage of 359% in 2008, a solvency ratio of 121% and a median effective tax rate of 25% over the last decade, this chart shows the relationship between the combined ratio and ROE for the different investment yields. These mechanics are representative of all major markets, although only US figures are shown.
Figure 1 15% ROE Combined ratio and investment yields determine the ROE 12% 10%
5% 5% 4% investment 1.5% yield 0% 2.5%
93% 95% 97% 99% 101% 103% 105% 107% Combined ratio Situation of 2008
9 AM Best and Highline. Accident-year claims data are based on Schedule F data.
Swiss Re, sigma No 5/2009 13 How much insurance do businesses buy and why?
In 2008, the industry achieved a combined ratio of 105% and an investment yield of 2.5%, which results in a market ROE of 1.5%.10 Every decrease of one percentage point in the combined ratio improves the ROE by about 0.6 points. And every increase of one percentage point in investment income improves the ROE by 2.2 points. For every percentage point decrease in the investment yield, the combined ratio needs to increase by about four points to offset the decline in profitability.
While we expect a recovery of investment yields from the distressed levels of the second half of 2008, we cannot expect them to reach pre-crisis levels any time soon. Central banks will keep short-term interest rates at low levels and long-term rates will only rise gradually if economic recovery is weak. As a con- sequence, yields on the US 10-year Treasury note, for example, will end 2009 at around 3.6% and rise only modestly to 3.8% by the end of 2010. In order to achieve a ROE of 12% under the listed assumptions, a 4% investment yield requires a combined ratio between 94% and 95%, which is about ten to eleven points lower than in 2008.
The market for large liability risks is dominated by a few players
Markets for complex liability risks The commercial liability insurance market is dominated by a few global insurers are more concentrated. and large predominantly national insurers. The market concentration is higher in the lines that cover complex risks or require larger amounts of cover. The key global players competing for business in North America and Europe are ACE, Chartis11, Allianz, AXA, Chubb, QBE, The Travelers, XL Insurance, Zurich Financial Services and Lloyd’s.
Table 4 Equity (USD m) US UK Germany France Italy Canada Ranking of leading commercial liability AXA 55 000 6 3 1 6 8 insurers in the largest markets, 2008 Chartis 52 700 1 3 8 2 Allianz 49 500 12 9 1 4 3 29 The Travelers 25 300 2 10 13 Zurich 22 100 3 2 5 5 6 Lloyd’s 18 300 1 1 ACE 14 400 7 7 14 Chubb 13 400 4 11 7 QBE 9 500 8 XL Capital 6 600 10 23
Sources: national insurance associations, AM Best
10 The actual ROE in 2008 was 0.7% due to an unusually high effective tax rate of 69%. 11 The P&C arm of AIG was rebranded as Chartis on 27 July 2009.
14 Swiss Re, sigma No 5/2009 Chartis was the market leader In the US, Chartis was the market leader with 12% of liability lines in 2008, fol- in US liability markets in 2008. lowed by The Travelers and Zurich Financial Services with 6% each. The top ten firms in the US accounted for 48% of total liability lines premiums. In the United Kingdom, however, the top five liability insurers – Zurich Financial Services, Royal & Sun Alliance, Chartis, Aviva and AXA – generated almost half of the premiums. Lloyd’s share was 15%. The leading liability insurers in other selected markets were Allianz (Germany), AXA (France), Generali (Italy), Lloyd’s (Canada) and Tokio Marine (Japan).
European national data do not fully The market share of Lloyd’s is difficult to measure in various markets because it capture liability business written in is not a single carrier, but rather a marketplace. It often does not operate through other EU countries. licensed carriers, and it assumes cross-border risks. Distribution is exclusively through brokers. The market share of the global players in Continental Europe is also difficult to measure because national data do not fully capture the business written by companies domiciled in other European Union (EU) member states. All the above-mentioned non-European global players write considerable amounts of liability business in various countries through their UK subsidiaries.
Large domestic insurers play an impor- Apart from the global players, there are many “domestic” insurers that dominate tant role in providing the primary layer. the regional liability markets. Typically, the specialised liability insurers focus on the primary layer, for which they may provide integrated programmes. They mostly offer traditional lines of business and a few specialty lines. However, they are highly committed to their local clients, maintaining capacity through swings in the underwriting cycle. Examples of such companies are SMABTP in France, and HDI-Gerling in Germany.
The following are some of the important characteristics of the market leaders:
Large balance sheets: are necessary in order to provide sufficient capacity for the substantial exposures of large corporations, although large programmes are often co-insured. Currently, the market leaders are providing individual capacity of USD 100m or more.
Solvency: strong capitalisation is necessary to provide the full benefit of risk transfer. Extreme risk scenarios are often correlated and equity capital provides the buffer for these unforeseen loss events. The financial strength of many clients and insurers is influenced by the same developments in financial markets. The value of risk transfer is highest in times of financial or economic crisis.
Reinsurance cover: Risk transfer via reinsurance – in lieu of balance sheet capi- tal – is an option for dealing with extreme risk events. The leading players are protected by large reinsurance treaties providing cover on a fully automatic basis.
International experience: most large corporations are operating globally and are exposed to different liability regimes via export or foreign operations. Insurers must be able to service and support their clients relative to their international exposure. Globally operating insurance companies maintain respective networks, whether through their own operation or through partnership with other carriers, at least in major countries or around the world.
Swiss Re, sigma No 5/2009 15 How much insurance do businesses buy and why?
Claims handling expertise: larger corporations are more likely to be involved in large scale litigation. Experience in dealing with high profile and complex claims scenarios is critical in order to effectively manage cases, contain claims costs and protect the client’s interests (eg minimising reputation risk). Equally impor- tant is a broad scope of local expertise in dealing with the claims of their inter- nationally active clients.
Financial markets capabilities: insurance risks and financial market risks are becoming increasingly intertwined. This is relevant for understanding risks, designing products and managing exposures to reduce the cost of risk transfer.
According to a global survey by Aon, commercial clients expressed the following priorities in their choice of insurers: (1) financial stability, (2) value for money, (3) flexibility, (4) claims service and (5) speed and quality of documentation. The top ten most respected insurers named in this survey were Chartis, ACE, Zurich, Chubb, XL, FM Global, Swiss Re, Travelers, Lloyd’s and Allianz.
The role of brokers in commercial insurance
Large corporations tend to purchase Commercial insurance is primarily distributed through brokers. The large com- commercial insurance through brokers. mercial business is almost entirely placed through brokers.12 According to a RIMS survey, 96% of the membership corporations use a broker to place their insurance programmes. The market for commercial insurance brokerage is highly concentrated with the three large global players Aon, Marsh & McLennan, and Willis accounting for an estimated 60% of global brokerage revenues.
For small and medium enterprises, For small and medium-sized enterprises, the brokers’ share of commercial insur- distribution channels vary by region ance business varies widely by region and country. In the Anglo-Saxon countries and country. and Latin America, the brokers’ market share is very high. In Continental Europe, their market share is low, but still significant. They are rarely called upon in the major Asian countries.13 .
12 In Germany, many large corporations buy their insurance cover through in-house brokers, which provide principally the same services as external brokers, but are normally better embedded in the corporation’s risk management tasks. However, the main reason for this speciality is the German law prohibiting commission reimbursements to the insured, but not the in-house brokers (http://www.bfv-fvv.de). 13 For more details on commercial brokers, see sigma No 2/2004 “Commercial insurance and reinsurance brokerage – love thy middleman”.
16 Swiss Re, sigma No 5/2009 The role of captives
Non-traditional solutions, such as captives, Risk transfer is not the only way to finance risk. Liability exposures can also be can protect against hard-to-insure risks. handled by alternative risk transfer methods such as self-insurance and captives. It is estimated that large US corporations tend to spend just as much on alterna- tive risk transfer methods as they do on traditional premiums paid to insurance carriers.
The captive market is dominated by We estimate the global volume of captive premiums at USD 50–60bn. US cor- US long-tail risks. porations account for 50–60% of the volume. In the US, liability lines account for one-third of premiums, while workers’ compensation, commercial auto and healthcare account for most of the remaining captive premiums. The business mix for non-US captives is more geared towards commercial liability and com- mercial auto. There are other forms of US-specific self-insurance in long-tail lines – such as qualified self-insurance and risk retention groups – that do not exist in other markets.
Captives bundle and diversify risks Captive insurance companies are often an integrated part of the risk manage- and provide access to the (re)insurance ment and financing tool box of large corporations.14 Through captives, corpora- markets. tions can better bundle and diversify their risks, and they can directly access the global insurance and reinsurance markets. On the other hand, captives need to be capitalised and tend to drive up management costs. Moreover, if captives lack the required local insurance licenses, they need to establish front- ing arrangements with admitted insurers.15
The use of captives among large The use of captives continues to grow among large corporations. A recent study corporations is high in Europe and by Aon analyses this trend.16 Of the 705 captive sponsors among the world’s North America, but lower in Asia. largest 1500 companies, 50% are headquartered in the Americas, 41% are located in Europe, the Middle East and Africa, and 9% are in Asia. In some countries, the utilisation rate of captives by the largest corporations is very high – eg in the UK (79%), Sweden (77%) and Australia (73%). At the other end of the spectrum, Japan (14%) and Italy (15%) have very low utilisation rates. There is little difference in the take-up rate between Continental Europe (54%) and North America (57%). Asian companies have a very low take-up rate (17%).
Table 5 Companies in Companies Number Take-up Global utilisation of captives by Industry the global 1500 with captives of captives factor in % the largest 1500 companies per sector Finance/insurance 490 273 421 56 Retail trade 114 48 66 42 Pharmaceutical, chemical 65 39 61 60 Transportation 55 29 40 53 Communications 47 18 27 38 Oil & gas (extraction) 28 17 32 61 Health services 10 6 7 60 Total 1500 705 1061 47
Source: Aon (2008), “Global 1500: A Captive Insight”.
14 sigma No 1/2003 “The picture of ART”. 15 CICR (2009). “Fronting: the good, the bad, and the alternative”, March, pp 6–12. 16 Aon (2008), “Global 1500: A Captive Insight”.
Swiss Re, sigma No 5/2009 17 How much insurance do businesses buy and why?
Pools are another alternative risk Pools, which are risk sharing arrangements between member corporations or transfer method used by corporations insurers to mobilise sufficient capacity for very large risks, can also be used as and insurers to manage risk. alternative risk carriers. Pools are typically organised on a national basis and sometimes operate like a reinsurance organisation, with the individual members ceding the risk and their premiums to the pool to cover a specific risk class. Aviation and nuclear power plants are examples of liability risks covered by pools.
Risk retention groups are specialised Risk retention groups (RRG) and purchasing groups (PG), introduced in the US mutuals for US liability risks. in 1986, are alternative mechanisms for US corporations to access liability insurance.17 RRGs are specialised liability insurance companies incorporated as mutuals that retain risk, but require capitalisation by the members. PGs are groups of companies within the same industry that collectively purchase liability insurance. PGs do not retain risk, but purchase insurance from an insurer that issues the policies and serves as the risk bearer.
Capital markets are expected to Finally, the capital markets are an alternative source of capacity for insurance play an increasing role in assuming risks that might have a future role in assuming liability risks. For example, insur- long-tail risks. ance-linked securities – such as catastrophe bonds – can be used to transfer risk to the capital markets. However, establishing liability bonds is a challenge due to the need to define triggers and the long-tail nature of liability risks. Only one bond so far has covered commercial liability risks (eg umbrella general liability). It was from OCIL, a mutual that manages liability risks for the energy industry. Future capital market products could relate to specific companies (indemnity triggers) or broader indices. There could also be a role in transferring reserves risk.
17 RRGs and PGs are limited to commercial liability lines of business. Excluded are workers’ compensation, property and personal lines.
18 Swiss Re, sigma No 5/2009 What are the key issues?
The risk of underestimating liability claims
Commercial liability claims are growing Statistics show that over the long term, commercial liability claims growth ex- faster than GDP. ceeds GDP growth substantially in the largest insurance markets (see Table 7). Companies need to be aware of issues that might lead to future liability claims, such as those related to production processes or their role as employers. The same applies to insurers that assume such risks. Risks that cannot be mitigated need to be priced into the products and the insurance.
Clear trends exist, but fluctuations Clear trends exist in liability, though there are huge fluctuations in these trends. occur due to inflation, technology Some fluctuations are due to inflation, while others are related to technological and legal developments. changes. Legal developments also play a significant role. After periods of esca- lating claims – such as during the mid-1980s – claims trends assumed in more recent years (since 2002) may be overestimated. In such cases, companies and insurers benefit from lower claims and profits from over-reserving. Conversely, claims trends may be underestimated after episodes of falling claims and/or general inflation, such as after the recent period from 2002 to 2007.
In the following section, the major causes of claims escalation are discussed. They include inflation, societal trends towards higher claims, emerging risks and legal developments.
Higher prices cause higher liability claims
Inflation severely impacts claims. Inflation can have a severe impact on claims. For example, a permanent addi- tional 2% annual escalation in US general liability claims leads to an 8.7% increase in the nominal ultimate value of claims payments. Because liability claims often involve a substantial lag time before they are settled, the effect of inflation is much higher in liability than in lines of shorter duration. Table 6 shows how claims inflation affects ultimate claims payments by line of business.
Table 6 Additional annual claims escalation Effect of additional claims escalation 1.0% 2.0% 3.0% and lower investment yields on US lines Change in the nominal ultimate value of business Homeowners 1.5% 3.0% 4.5% Personal auto 2.2% 4.5% 6.8% Commercial multi-peril 2.9% 5.9% 9.0% Commercial auto 3.0% 6.1% 9.3% Other liabilities 4.3% 8.7% 13.4% Medical malpractice 4.3% 8.7% 13.4% Product liability 5.2% 10.6% 16.4%
Sources: Swiss Re Economic Research & Consulting, A.M. Best
What are the variables which best explain claims inflation? Regressions for longer periods show that among the variables tested – consumer price index, wages and healthcare expenditure – the latter showed the highest correlation with liability claims in most countries. It is not year-to-year healthcare expendi- ture, but five-year healthcare expenditure which shows high correlations. The results also reveal that correlations dropped after 1985.
Swiss Re, sigma No 5/2009 19 What are the key issues?
Societal trends as the deeper cause for liability claims increase
Liability claims have been rising faster The ratio of liability claims growth to GDP growth ranges from 1.1 to 1.4 in the than nominal GDP growth. US, Canada and the larger European economies.18 In the US and Germany, for every 1% increase in nominal GDP, general liability claims have risen by 1.3%. Although Japan experienced the highest growth in liability claims in relation to GDP – a ratio of 2.3 – liability claims were catching up from a very low level.
Healthcare expenditures were affecting Of the macroeconomic variables analysed, liability claims were generally more liability claims growth. closely correlated with total healthcare expenditures than with CPI inflation or wage inflation, especially when looking at multi-year average growth rates (see Table 7). Health expenditures seem to be growing at roughly the same pace as liability claims in the long run.
Table 7 Long-term growth trends of liability claims incurred in major markets
US [1] Canada [1] Germany UK [1] France Italy Japan [2] Period 1960–08 1973–08 1973–07 1970–08 1971–08 1970–08 1970–05 Compound annual growth rate – Liabilty claims incurred 9.4% 10.3% 6.0% 10.8% 8.9% 13.7% 12.9% – Liabilty premiums written 8.6% 11.0% 6.1% 11.0% n.a. 14.4% n.a. – Nominal GDP 7.1% 7.5% 4.6% 9.2% 7.8% 10.6% 5.6% – Inflation [CPI] 4.3% 3.9% 2.8% 6.3% 5.2% 7.6% 3.3% – Wages 4.7% 5.4% 3.3% 8.3% 7.7% 9.5% 4.8% – Health expenditures [3] 9.9% 8.9% 6.4% 8.2% 10.0% n.a. 7.5% Ratio of liability claims growth versus – Nominal GDP 1.32 1.38 1.29 1.18 1.13 1.30 2.30 – Inflation [CPI] 2.19 2.66 2.13 1.72 1.72 1.82 3.95 – Wages 2.02 1.89 1.83 1.30 1.15 1.45 2.70 – Health expenditures [3] 0.96 1.16 0.93 1.32 0.89 n.a. 1.72
Sources: Liability claims from insurance supervisory authorities, GDP from Oxford Economic Forecasting, Health expenditures from OECD [1] net after reinsurance [2] claims paid [3] OECD data only through 2005, estimates for 2006
Socio-economic drivers of claims costs What is the reason for the strong growth? Liability business is exposed to a need to be monitored. number of different drivers. The industry needs to monitor shifts in societal trends and risk perception for a number of current issues in order to assess the possible future impact on the business. These include:
̤̤ The value of life and the cost of maintaining it: the exposure of the majority of liability lines is directly impacted by advances in medical technology and the ability of such advances to prolong human life at ever higher costs. The increasing value society attaches to an individual life often means that all medical options must be fully exhausted in order to maintain and prolong life.
18 These are simply empirical observations concerning relative growth rates; they do not imply causality.
20 Swiss Re, sigma No 5/2009 ̤̤ Increasing awareness of environmental issues: greater awareness and changing perception of environmental risk, particularly in the light of climate change and biodiversity loss19, may lead to an increased number of future claims. An ever evolving and broadening range of claimants and defendants are exploring legal avenues of redress to stop the externalisation of environ- mental costs. These judicial processes are expected to become more sophis- ticated over time. ̤̤ Higher wealth leads to higher liability claims: as economies develop and the wealth of individuals increases, so do potential liability claims. Equally, stock market valuations have a direct effect on potential liability payouts in some lines of business (eg directors & officers insurance). ̤̤ Increasing interconnectedness: in an increasingly globalised world, liability risks will grow because of wealth and the increasing interconnectedness of the developed world.
Emerging risks as a source of claims escalation
Future liability claims can be influenced While there is hardly any doubt that liability claims are on a rising trend, the by a range of environmental factors. uncertainty about where and when claims will escalate is high. This is an issue in the research on emerging risks. History shows that the reasons for new claims are numerous: they can be triggered by political, regulatory, economic, technological, societal and legal developments and are usually difficult to quantify ex ante.
Emerging risks are covered by liability Figure 2 shows survey results that identify emerging risks as the biggest chal- policies unless they are excluded. lenge facing liability insurers from the insurance buyer’s point of view. Insurance underwriters regard them as the third most important risks after historical reserv- ing and pricing.
Figure 2 Underwriter Perception of future challenges perception to liability insurers
Buyer perception 0 20 40 60 80 100
Historical reserving Sustained underwriting profitability – rate adequacy Emerging risks Cost of corporate compliance Increased client self-insurance Cost of increasing compensation culture Investment returns Other
Source: Aon (2005), European Property, Liability and D&O Report.
19 Swiss Re (2007), “Insuring environmental damage in the European Union”
Swiss Re, sigma No 5/2009 21 What are the key issues?
A survey by Aon provides a list of emerging risks that concern the corporations’ risk managers. This list includes employment practices, food safety, environ- mental pollution and financial loss as the most important risks (see Figure 3), with no clear shared view of what is most important.
Figure 3 Employment-related 14% Other Ranking of the most important emerg- ing risks Other 16% Food and beverage industry 13% USA exposure Pharmaceutical industry USA exposure 5% Environmental 13% General product liability & recall Pharmaceutical industry 5% General product Electric & magnetic fields liability & recall 7% Financial loss 10% Legal environment Electric & magnetic fields 8% Legal environment 9% Financial loss
Environmental Source: Aon (2005), European Property, Liability and D&O Report. Food and beverage industry
Employment related Emerging risks relate to the advancement Risks to the human body arising from electromagnetic fields produced by power of new technologies, the discovery of lines, mobile phones and other mobile communication equipment have been new hazards … the subject of intense debate. Equally, there is much controversy surrounding the effects of genetically modified food and nanotechnology on the environment and the human body. In many cases, very little or no scientific evidence is avail- able to prove or disprove a causal link between such technologies and health impairments to exposed individuals and/or future generations.
… or to new legal developments relating Handguns and obesity have also been acknowledged as emerging risks in the to known hazards. US. Efforts are now being made to hold handgun manufacturers and fast food producers liable for known risks related to the intended use. Similarly, the further emergence of risks due to asbestos, silicosis, mould, etc are more dependent on legal developments than the evolution of scientific evidence. Governments have the important role here of maintaining a stable and fair legal and jurisdic- tional landscape.
Emerging risks need to be actively Fortunately, none of these emerging risks has evolved into the next asbestos – monitored and mitigated to preserve yet. It is important to note that asbestos risks were known decades before the insurability. magnitude of the losses was felt. Nevertheless, emerging risks are a major challenge for the insurance industry as they cannot be assessed with traditional actuarial methods and are highly correlated once precedence verdicts have been established. In the early phases of assessing emerging risks, insurers must analyse complex exposures, ensure that they and their clients adopt risk prevention measures and do their utmost to limit accumulation risk.
22 Swiss Re, sigma No 5/2009 Legal and jurisdictional developments and liability risks
The legal system has been subject to major changes in the past. Many of the developments started in the US, where the tort system has been “moving away from a system of fault and recompense to one concerned chiefly with wealth distribution”.20 The trend of widening the scope of liability is rapidly increasing in Europe and Asia as well.
The US legal system has changed dramatically in recent decades One driver of liability claims growth The shift from tort liability to strict liability without fault (called “strict liability”) has been the shift to strict liability. has driven liability claims growth. In the beginning, the sole trigger for liability for damages was fault on the part of the damaging party or tort-feasor. However, technological change brought many new risks, which led to the evolution of liability based on causation. Irregularities, malfunction or failure to observe caution all fall under the umbrella of strict liability. More recently, environmental liability has expanded to include the compensation for damage to public goods (eg damage to ecosystems).
Another driver is the expanding scope Liability is also growing due to the expanding scope of compensation. The origi- of compensation. nal scope of liability law was to compensate third parties for bodily injury or property damages and consequential financial losses (ie loss of profit or income, increase in expenses as a consequence of bodily injury or property damage).21 However, compensation for pain and suffering has now become an increasingly common feature with high awards in the US and strong growth trends in many European countries and emerging economies.22
Punitive damages add to the The awarding of punitive damages – notably in the US – is also on the rise. These uncertainty of US jury verdicts. payments exceed the actual compensation for damage and are an aspect of penal law within the framework of civil cases. Punitive damage awards can reach spectacularly high sums, especially in the lower courts. While extreme awards often get substantially reduced in the higher courts, they are still a major cause of uncertainty and a driver of legal costs.
Also, the number of claimants Finally, the number of claimants and liable parties is driving the growth in liability. and liable parties is growing. A trend evolved whereby lawyers and claimants are attempting to extend liability beyond the person or corporation that caused the damage to a third party. In the US, many liability suits specifically target “deep pockets” rather than looking strictly at cause and effect. Increasingly, parties that are only indirectly involved or are far removed from the cause-effect chain are being held responsible. Quite apart from the justice aspect, this development will seriously impair the ability to assess liability risk and insure it.
20 Liedtke, Patrick (2005), “The Economic System as Catalyst for Evolving Liability Regimes”, The Geneva Papers, volume 30, pp 343–351. 21 Compensation also increasingly includes retroactive liability and liability for prospective damages (eg asbestos exposure without a developed medical condition). 22 According to Tillinghast, US liability costs are equally divided between awards for economic losses and non-economic losses, such as pain and suffering and punitive damages.
Swiss Re, sigma No 5/2009 23 What are the key issues?
The ever growing liability for asbestos
Asbestos is one of the most mature US mass torts, dating back over 30 years. From the mid to late 1990s, the number of new asbestos claims filed and old claims settled had stabilised. Many insurance analysts began to believe that the worst was over. Billions of dollars had already been spent to settle thousands of claims. Also, many asbestos producers had already declared bankruptcy and gone out of business. Moreover, many of the seriously ill had already died and their survivors had been compensated. But by 1999, a number of interrelated factors spurred a new wave of litigation. The claimants’ bar was successful in creating new theories and techniques for widening the range of claimants and defendants.
One of the most marked changes in asbestos litigation has been a widening of the range of defendants to companies without fault. Since most of the manu- facturers of asbestos had already been bankrupted by asbestos litigation, law- yers began going after companies that were less directly linked with asbestos. Increasingly, it was not only manufacturers of the material, but users of the prod- ucts that were being sued. Rand23 estimated that some 8 400 companies have been sued over asbestos-related claims. As more companies hit with asbestos lawsuits file for Chapter 11 bankruptcy, lawyers rush to file cases before it is too late. Sixteen asbestos manufacturers went bankrupt in the 1980s due to asbes- tos-related losses, 18 in the 1990s and another 36 between 2000 and 2004.
Another trend with an even greater impact on the expansion of litigation was the filing of claims on behalf of people with little or no current disability, a condi- tion characterised as “non-malignant”. More than 90% of the claims filed in the late 1990s and early 2000s were by non-malignant claimants. The filing of massive class action lawsuits and the bundling of strong cases with scientifically weak cases have contributed to this surge in claims. By 2002, roughly 730 000 individuals had filed asbestos claims.
According to A.M. Best, the ultimate cost of asbestos claims has reached USD 65bn for the US insurance industry. The cost to foreign insurers has been estimated at approximately USD 30bn. The largest share remains uninsured. The costs to the US economy, including costs borne by non-US reinsurers and uninsured amounts, has been estimated by other industry experts at USD 200–275bn.
23 See Carroll, Stephen J. et al. (2005). Asbestos Litigation, Rand.
24 Swiss Re, sigma No 5/2009 Development of a compensation culture in the European Union Liability dynamics are expanding Liability dynamics are different across the member states. There are develop- in Europe at the national level … ments at the national level as well as at the European Union level. Developments in both are connected and influence each other. ̤̤ At the national level, strict liability is extending significantly. ̤̤ Damage awards are increasing, especially those awards that concern pain and suffering (non-pecuniary damages). ̤̤ Collective redress is developing. Various member states have adopted collec- tive redress mechanisms. ̤̤ Italy and Germany have adopted variations of US-style securities class action mechanisms. ̤̤ Several countries already permit unrestricted contingency fee agreements, while others allow limited forms of contingency fee agreements. The UK and Ireland permit “no-win no-pay” agreements if they are not tied to a percentage of award recoveries.
… and via EU legislation. The European Commission is pursuing a policy of expanding liability. Some of its directives are designed to introduce new areas of liability, increase limits and/or require mandatory liability insurance. An example of this legislation is the 2004 environmental liability directive that introduced a polluter-pays-all regime for environmental impairment in the European Union. Another example of EU legis- lation affecting liability is the 2002 Insurance Agents and Brokers Directive, which requires brokers to purchase professional indemnity insurance or any other comparable guarantee against liability claims arising from professional negligence. Finally, the addition of ten new members to the EU in 2004 has expanded the scope of the tort system to these countries. For example, limits of insurance for motor third party liability have been raised to match EU minimums.
Liability dynamics in other regions Liability regimes and exposures The strong growth in liability exposure in Asia is based on strong economic are expanding rapidly in Asia. fundamentals and a broadening of liability regimes. Examples are the adoption of stronger consumer protection legislation and the establishment of product liability laws. During the 1990s, Australia, Korea, Japan, Taiwan, Indonesia and the Philippines introduced product liability laws similar to the EU Directive of 1985. China has also enacted several laws enhancing consumer rights.24 The Law Reform Commission of Hong Kong recently published a consultation paper on class actions proposing the introduction of a mechanism for multi-party litigation in Hong Kong.25 While this is still in the discussion stage, it mirrors developments in other countries and regions.
24 Kellman, J. and L. Nottage (2007). Europeanisation of Product Liability in the Asia-Pacific Region: A Preliminary Empirical Benchmark. Sydney Law School, Legal Studies Research Paper, May. 25 http://www.hkreform.gov.hk/en/news/20091105.htm
Swiss Re, sigma No 5/2009 25 What can insurers do to keep liability risks insurable?
Liability insurance is interwoven with The liability business is interwoven into the complex fabric of society. No other technological and societal risks … line of business is as difficult to underwrite and price. Apparently, subtle changes can, over time, have a significant effect on the injured party, the liable parties and the parties that assume ultimate financial responsibility for the injury (eg in- surers). Governments, companies and their insurers carry a shared responsibility for keeping this network of interactions sustainable.
… therefore governments, corporations Governments, as the guarantors of legal certainty, set the legal framework of and insurers carry a shared responsibility rules and enforcement. Steps can be taken at every step in the risk chain – from for the insurability of risks. risk assessment to mitigation and risk transfer – to reduce the overall cost of risk and keep it quantifiable and insurable. Companies and their insurers must un- derstand and monitor the triggers of liability claims and then reflect this in their enterprise risk management and actuarial models.
Product design (eg wording & policy Insurers must pay close attention to wording and policy language in order to language) and proper pricing are key manage their exposure to rapidly changing liability risks. Finally, the underwriting for insurers. process must at all times remain focused on maintaining control over exposures and underlying profitability. Understanding the numerous drivers of the liability business is key, not only to fully comprehending and accurately underwriting the risks related to it, but also to exploiting the opportunities within it.
What can governments do?
Governments can play a major role in By increasing legal certainty and speed of resolution, governments can play an reducing the risks in the tort system. important role in the future of liability insurance. Good policy consists of creat- ing an environment, in which citizens are fairly treated and companies neverthe- less can operate and innovate. Both from the company’s and the insurer’s point of view, it is important that the cost of liability regimes remains affordable and the legal and jurisdictional framework remains predictable. Governments can improve the legal framework by: ̤̤ limiting frequent changes to liability rules ̤̤ implementing new liability rules with ample lead-time and public discussion ̤̤ avoiding court procedures/legal constructs that contribute to long gaps until resolution as well as unpredictable outcomes, such as joint and several liabili- ty, and jury shopping ̤̤ limiting financial incentives of the trial bar in the outcome of cases (eg excluding punitive damages from the base of contingency fees) ̤̤ eliminating retroactive liability
Examples of tort reform measures in the framework of Anglo-Saxon legal systems are Australia and the US.
26 Swiss Re, sigma No 5/2009 Tort reform in Australia 2002/2003 Rising claims and concerns about In 2001, sharply rising liability claims and the collapse of HIH, the second largest premiums and availability of cover led to insurance company, led to concerns about rising insurance premiums and the changes in the tort system in Australia. availability of liability cover. The Australian Government commissioned a com- mittee to provide a report on “the Law of Negligence”. The “IPP Report” was released in September 2002, containing a catalogue of recommendations for legislative actions. While the original goal of passing a national law failed, a majority of the states and territories implemented most of the recommendations through a combination of amendments to existing laws or the introduction of new legislation. The reform consisted of measures to narrow the scope of potential liability, reduce the damages that could be awarded and introduce upper and lower limits for damages to be paid for loss of earnings as well as pain and suffering.
The reform brought many of the intended results. Insurers managed to stabilise their results. Moreover, the costs for liability cover also fell and the number of claims decreased.26
Tort reform in the US The recent slowdown in US class action US tort reform initiatives are mostly conducted at the state level and have activity was only temporary. primarily tried to limit lawyers’ fees and non-economic compensation, including punitive damages. Some of these caps were later overturned by state supreme courts. Other initiatives have attempted to limit mass tort litigation at the federal level. Multiple corrective steps were taken to address the surge of liability claims that emerged in the late 1990s. Statistics show that from 2002 to 2006, the number of US federal class actions fell. This was partially due to the strong performance of the economy. During this period, the number of corporate failures, which drive securities litigation, was unusually low. At the same time, much of the litigation activity shifted away from federal class actions to state court proceedings. Therefore, the overall level of litigation activity never declined as much as statistics regarding federal case filings show. Lately, the financial crisis has triggered a new wave of class actions. The longer term outlook remains uncertain.
26 Pearson, Estelle and Lisha, Ruth (2007), “Public Liability Tort Reform – Assessing the Impacts an Update”. Paper presented to the Institute of Actuaries of Australia’s 11th Accident Compensation Seminar, April.
Swiss Re, sigma No 5/2009 27 What can insurers do to keep liability risks insurable?
The importance of an appropriate product design
Changes in product design can Product design is of particular importance in liability insurance. The insurance limit exposure, but not all issues industry has developed a range of definitions and clauses to limit unintended have been resolved. coverage for liability risks. However, several issues still need to be addressed, including the following: ̤̤ As it is notoriously difficult to foresee changes in behaviour, law and court practices, new clauses can often only be introduced after initial losses have already occurred. ̤̤ Insurance contract clauses are regularly contested in court and sometimes have been declared void or reinterpreted by courts. ̤̤ New product exposures can be difficult to assess depending on final user and scope of use.
Exclusions Exclusions are used to separate risks Undesirable, uninsurable or high hazard exposures, such as environmental lia- into different policies. bility, are often mitigated by excluding them from coverage under the standard policy and requiring the insured to procure coverage separately. By eliminating certain risk segments, underwriting becomes more precise, resulting in prices that are commensurate with risk levels. However, risks that are considered unin- surable by insurers may be excluded without the option to purchase separate cover.
Trigger definitions Long-tail liability risks require a carefully In the mid 1980s, the US liability insurance industry was confronted by a number defined trigger for the insured event. of changes in the legal environment that resulted in high and unexpected finan- cial burdens. This included the retroactive application of environmental liabilities to comprehensive general liability and the emergence of asbestos cases, which often led to latent claims. The long-tail nature of some risks, such as product liability and latent injury, and the ever expanding interpretations of liability have created high levels of uncertainty for insurers under the standard occurrence policies.27 The liability crisis of the mid-1980s became a profitability crisis for insurers, ultimately leading to a capacity crisis.
Claims-made policies limit the insurers’ The “claims-made” policy was one of the innovations devised by insurers to exposure to long-tailed, latent risks. resolve this crisis. Only claims which are reported during the policy period are covered by this type of cover, irrespective of the date of the occurrence. Coverage is provided based on a thorough review of updated information. The advantage for the insurers lies in the significant reduction of the development risk. Insura- bility increases and the price per cover decreases, facilitating coverage for other- wise hard-to-insure risks.
Retroactive and discovery periods allow Claims-made covers can also include a retroactive period and a discovery period. more flexibility for the insured. The retroactive period limits the cover to losses which occur after an agreed date (retroactive date). Losses which occurred earlier are excluded. The discov- ery period allows the insured party to use an extended reporting period (tail pe- riod) and is typically purchased for an additional premium.
27 Subject to restrictions and interpretations of the respective legal framework, occurrence-based policies cover claims that arise from events that occur during the policy period, regardless of when the insurance company is notified of the loss or claim.
28 Swiss Re, sigma No 5/2009 The Bermuda form uses a hybrid of Other modifications were implemented with the “Bermuda form”, which is a occurrence and claims-made triggers. hybrid of an occurrence and a claims-made form. Bermuda forms are typically used for high excess liability policies. To be valid, a claim must occur after the specified retroactive date and must be reported to the insurer during the policy period (ie occurrence reported concept). Another notable feature of this policy form is the possibility to combine related occurrences, also referred to as inte- grated occurrences or batch cover. However, policies written on a “Bermuda” form typically do not provide a drop-down feature, which is provided in the standard US occurrence policy form.28
The claims series clause collates A similar effect is achieved by the European claims series clause. A claims series claims from the same cause. event is defined by relating all claims from the same specific common cause. The per event or annual limits of the policy are the maximum amounts covered for all claims arising from one cause. Similar to the Bermuda form, this prevents the potential stacking of limits over several underwriting years for a single insured event due to the same fault.
Quantitative limits Quantitative limits are necessary Quantitative limits – per event as well as aggregate limits per time period – are to reduce ambiguity. important for transforming ambiguous underlying risks into insured risks with known maximum outcomes. This includes, for example, the use of per occurrence and aggregate sublimits for certain higher hazard exposures, such as environ- mental pollution liability, professional liability and limited pollution coverage. Limiting the maximum loss per risk improves risk consolidation in an insurer’s portfolio and reduces capital requirements. Defining and limiting the insurer’s liability is also important for limiting the success of lawsuits designed specifically to seek damages from individuals or organisations with deep pockets.
Defense cost limitation is important There are markets with unlimited defense costs outside of the policy limit (eg the to assess maximum loss. USA). Since these costs can be significant, in particular for policies with US ex- posure – where litigation costs are particularly high – it becomes impossible for insurers to estimate their maximum loss. Where allowed, insurers control this exposure by capping defense costs at the per event limit and annual aggregate.
Deductibles and co-insurance Deductibles and co-insurance A standard solution to mitigate the problems of adverse selection and moral help to reduce adverse selection hazard is the introduction of deductibles and/or co-insurance in the contract. and moral hazard. The effect is a better alignment of the financial interests of insurance buyers and insurance carriers. Improving the alignment of interests can even become the aim of public policy. For example, the new law on the Adequacy of Management Board Compensation in Germany introduces a mandatory deductible for D&O policies. As a result, members of the management board who commit breaches of duty or employment-related wrongful acts retain some personal risk because they cannot be 100% compensated by their companies’ D&O policies. However, there are private insurance solutions for these deductibles.
28 A drop down clause provides cover through the excess liability policy for ground-up losses if the under- lying limits are diminished or exhausted.
Swiss Re, sigma No 5/2009 29 What can insurers do to keep liability risks insurable?
Deductibles improve efficiency by The use of deductibles also eliminates small claims. Since processing a claim eliminating small claims from the involves some level of fixed costs that are partially independent of the size of the insurance cover. claim, insurers that focus on larger claims can reduce loss adjustment expenses. Therefore, deductibles are a way to increase the efficiency of liability insurance.
Index clauses Index clauses are used for an equitable Unexpected claims inflation is a major risk for insurers that gets multiplied in sharing of the effects of unexpected excess-of-loss reinsurance transactions. Market practices in Europe and Asia inflation. include the use of “index clauses” by reinsurers to ensure that deductibles and limits keep pace with inflation.29 Typically, a consumer price inflation (CPI) index or a wage index (eg average hourly earnings) is used as a measure of overall inflation. This keeps liability risks insurable for reinsurers, which in turn facilitates the insurability of the underlying primary risks. The application of index clauses to primary policies would be equally beneficial for dealing with long-term devel- opment risks.
The following are the most often used index clauses: ̤̤ Full Index Clause: the attachment point and coverage amount are adjusted fully with the index. ̤̤ Franchise Index Clause: the attachment point and coverage amount are adjusted fully with the index, but only if the accumulated inflation exceeds a certain level. ̤̤ Severe Inflation Clause: the attachment point and coverage amount are ad- justed with the index only if the accumulated inflation exceeds a certain level and only to the extent that the accumulated inflation exceeds this level.
There are different indexation concepts The application of the index also differs. The European Index Clause (EIC), which for sequential and lump sum payments. is geared towards an environment of sequential payments, applies the index to each payment date. The London Market Indexation Clause (LMIC), which ema- nates from an environment of lump sum settlements, indexes the total value of the claim to the date of the final settlement.
If there is only partial correlation The index clause provides an equitable sharing of the effects of unexpected between claims inflation and CPI inflation, claims inflation to the degree that there is a correlation with the economic the insurer incurs basis risk. factors used to define the index, which are usually CPI or wage indices. If this correlation is only partial as shown earlier (see Table 6), the insurer incurs some basis risk. Nevertheless, index clauses provide important protection against scenarios of prolonged severe inflation.
29 Index clauses are less prevalent in the United States and Canada.
30 Swiss Re, sigma No 5/2009 Structured solutions Structured solutions frequently recognise Structured solutions increase insurability with the use of risk financing elements, the policyholder’s loss experience. by expanding to multi-year periods with aggregate limits as is common in rein- surance, or by introducing experience accounts. These solutions are more rele- vant to the primary market. Asymmetric information between the insured and the insurer or ambiguity regarding the risk can limit the insurability of liability risks (eg inability to assess a probability or expected loss). Finite concepts can mitigate some of these limitations by containing the exposure for the insurer through aggregate limits and by spreading the risks for an individual policyholder over time. In addition, unique coverage clauses, such as the Sunset Clause and the Mandatory Commutation Clause, can also be used to contain exposures.
Frequency covers and new index-based solutions New cover structures focus on the Whenever there is ambiguity or moral hazard related to the severity of claims, frequency of claims or loss indices. insurability can be improved by offering frequency covers with a fixed payout per claims unit. The client retains the risk that the size of the claims deviates from the pre-defined fixed payments. Clients can still partially transfer their risks to insurers (ie the risk of the number of a defined class of claims), who may find that such solutions suit their risk appetite better, provided that the frequency can be sufficiently modelled. Related to this idea are products that do not indemnify actual losses, but structure payout schemes that are tied to market indices. These indices could be market losses or frequency indices.
Best underwriting practices and risk-adequate pricing
The underwriting process scales the One of the most challenging activities and certainly the most central process in risk and future profitability of insurers’ an insurance company is the underwriting process. After assessing risk expo- portfolios. sures and determining whether risks are acceptable for an insurer, underwriting involves deciding how much coverage to provide under preset conditions and what premiums to charge to insure the risks. It is a multi-faceted task requiring knowledge, coherent processes, dedicated strategies and ultimately judgement and an entrepreneurial attitude.
Monitoring of risks Continuous monitoring of the relevant First of all, the underwriting process requires a continuous monitoring and eval- risks … uation of existing and emerging risks to make informed and proactive decisions regarding insurability of these risks. This not only includes technological risks, but also economic, environmental, political and social risks.
… helps to improve the quality This is particularly important when pursuing new programmes, lines of busi- of underwriting. ness, classes of business or coverage enhancements. Proper due diligence is crucial to future success and should include input from underwriting, claims, loss control, actuarial, marketing/sales and regulatory compliance. The use of financial data has also become more important as part of the risk evaluation process. Risks of all sizes have financial implications that are magnified in turbu- lent times – eg when revenues are down and credit availability is restricted.
Swiss Re, sigma No 5/2009 31 What can insurers do to keep liability risks insurable?
Setting the right price Pricing requires detailed rate monitoring The pricing of risks requires detailed rate monitoring processes for both new processes and costing models. and renewal business along with tracking of premium and policy retention. Another prerequisite are actuarial models for the assessment of the technical premium that covers expected losses, expenses and cost of capital (costing). This includes appropriate “risk loads” in the costing of more volatile exposures that are subject to a greater amount of parameter uncertainty.
Insurers need to invest in the collection Insurers need to invest in loss databases in order to improve expected loss and analysis of claims data. models for commercial risks. This also requires the investment of dedicated actuarial resources necessary for developing the models. This task should be compared to investments undertaken by the insurance industry with regards to property risks.
Cost of capital and investment The costing of underwriting risks demands a proper inclusion of the investment environment are indispensable environment and the cost of providing capital. Declining yields on invested components of costing. assets require increasing charges for underwriting risks. Otherwise, the business becomes unprofitable. Also, constantly increasing capital requirements for insurance companies must ultimately be reflected in the costing.
Underwriters need a holistic It is also important to improve the underwriters’ understanding of the link understanding of all relevant between underwriting, costing and coverage terms and conditions, which costing components. are often analysed separately. These areas must be considered holistically to properly evaluate risks and improve profitability.
Integration of costing tools into the business architecture Integrating the costing into the Eventually, all this leads to the development, implementation and monitoring overall business architecture of a coherent strategy with respect to the underwriting (risk selection/retention) helps to enhance profitability. and costing of risks. A dedicated strategy will enhance the probability of achiev- ing an acceptable level of profitability and ROE over the duration of the cycle. This requires the integration of costing tools into the business architecture, a systematic tracking of risk-adjusted prices, feedback between claims and cost- ing, a systematic accumulation control with respect to threat scenarios, a con- sistently high level of underwriting diligence, and the continued commitment of management to the strategy.
Costing integrity and unbiased Strengthening the linkage between reserving and costing improves the ability reserving are critical to intelligent to react to trends in the results and the marketplace. Much of the volatility in cycle management. historical liability results was due to under-costing and under-reserving during the soft cycle, which in turn led to volume growth compounding the impact of the under-reserving. Companies tend to compensate for the under-reserving in the soft market by over-reserving in the hard market. This pattern prevents companies from fully capitalising on market opportunities and potentially leads to cycle mismanagement.
32 Swiss Re, sigma No 5/2009 Reinsurance as an important tool to mitigate risks
Liability risks are characterised by a low-frequency/high-severity pattern. Diversification within an insurers’ portfolio is therefore normally insufficient. Reinsurance plays an important role as a second stage of diversification, which is reflected by the higher cession rate of liability risks compared to standard property risks.
Primary insurers homogenise and mitigate risk portfolios through different forms of reinsurance such as proportional and non-proportional treaty reinsurance. Facultative reinsurance contracts provide cover for particular exposures in terms of size and risk profile.
The leading multi-line reinsurers also play an important role as a centre of know-how and competence with regards to risk assessment, product design, the underwriting process and pricing of risks.
Swiss Re, sigma No 5/2009 33 Conclusions
Insuring commercial liability risks remains a challenge for companies, their insurers and reinsurers.
Liability insurance is more exposed to uncertainty than most other lines of business. It is difficult to underwrite because of its long-term characteristics and its dependence on the interaction of a number of factors that are difficult to predict. These factors include macroeconomic developments, the changing industrial landscape, capital market developments, new technologies, medical progress, dynamic societal developments and continuing globalisation.
Meanwhile, the risk landscape is rapidly changing and the scope of compensa- tion continues to expand. Corporations and their insurers are facing higher claims that are in part driven by rising healthcare costs and changes in the legal system. Rising claims costs are not just a US phenomenon, though costs in the US are still by far the highest in the world; costs are also increasing in Europe and Asia.
To ensure that commercial liability is affordable for companies and that insurance and reinsurance can meet the needs of the society, companies, insurers and governments must respond to the challenges.
It is of utmost importance that governments contribute to legal certainty by avoiding frequent changes to liability rules, eliminating procedures that con- tribute to unpredictable outcomes and ending retroactive liability.
Companies have to proactively assess the liability exposures of their activities and find the right balance between that and conducting efficient levels of risk miti- gation to prevent undue risk. Monitoring the developments related to emerging risks is a task for companies as well.
Insurers contribute to the sustainability of commercial liability with sensible pro- duct design. By applying exclusions, carefully defined triggers and quantitative limits to policies and by purchasing reinsurance, insurers can transform ambigu- ous underlying risks into insured risks with known maximum outcomes. The use of deductibles and co-insurance is yet another way insurers can increase their ability to insure liability risks. Both insurers and reinsurers can reduce claims un- certainty and improve the ability to assess risks by standardising policy wordings.
Nevertheless, the best products and underwriting practices are no substitute for adequately pricing in expected claims escalation and the risks that things may develop even worse than predicted. This is especially important during the current low-yield environment with elevated long-term uncertainties regarding inflation risks. The industry’s past performance shows the dire need for adequate pricing.
In this environment, only insurers with a strong underwriting combined with up-to-date processes and a consistent strategy will be successful.
34 Swiss Re, sigma No 5/2009 Recent sigma publications
No 5/2009 Commercial liability: a challenge for businesses and their insurers No 4/2009 The role of indices in transferring insurance risks to the capital markets No 3/2009 World insurance in 2008: life premiums fall in the industrialised countries – strong growth in the emerging economies No 2/2009 Natural catastrophes and man-made disasters in 2008: North America and Asia suffer heavy losses No 1/2009 Scenario analysis in insurance
No 5/2008 Insurance in the emerging markets: overview and prospects for Islamic insurance No 4/2008 Innovative ways of financing retirement No 3/2008 World insurance in 2007: emerging markets leading the way No 2/2008 Non-life claims reserving: improving on a strategic challenge No 1/2008 Natural catastrophes and man-made disasters in 2007: high losses in Europe
No 6/2007 To your health: diagnosing the state of healthcare and the global private medical insurance industry No 5/2007 Bancassurance: emerging trends, opportunities and challenges No 4/2007 World insurance in 2006: premiums came back to “life” No 3/2007 Annuities: a private solution to longevity risk No 2/2007 Natural catastrophes and man-made disasters in 2006: low insured losses No 1/2007 Insurance in emerging markets: sound development; greenfield for agricultural insurance
No 7/2006 Securitization – new opportunities for insurers and investors No 6/2006 Credit and surety: solidifying commitments No 5/2006 World insurance in 2005: moderate premium growth, attractive profitability No 4/2006 Solvency II: an integrated risk approach for European insurers No 3/2006 Measuring underwriting profitability of the non-life insurance industry No 2/2006 Natural catastrophes and man-made disasters 2005: high earthquake casualties, new dimension in windstorm losses No 1/2006 Getting together: globals take the lead in life insurance M & A
No 5/2005 Insurance in emerging markets: focus on liability developments No 4/2005 Innovating to insure the uninsurable No 3/2005 Insurersʼ cost of capital and economic value creation: principles and practical implications No 2/2005 World insurance 2004: growing premiums and stronger balance sheets No 1/2005 Natural catastrophes and man-made disasters in 2004: more than 300 000 fatalities, record insured losses
No 7/2004 The impact of IFRS on the insurance industry No 6/2004 The economics of liability losses – insuring a moving target No 5/2004 Exploiting the growth potential of emerging insurance markets – China and India in the spotlight No 4/2004 Mortality protection: the core of life No 3/2004 World insurance 2003: insurance industry on the road to recovery No 2/2004 Commercial insurance and reinsurance brokerage – love thy middleman No 1/2004 Natural catastrophes and man-made disasters in 2003: many fatalities, comparatively moderate insured losses Swiss Reinsurance Company Ltd Economic Research & Consulting Mythenquai 50/60 P.O. Box 8022 Zurich Switzerland
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