A wave of insurance companies going to the wall as a result of high inflationary trends and high variability in long-tail liabilities.
The recent collapse of HIH is not an isolated failure on the global scene. Recent years have seen a wave of insurance companies around the world going to the wall. Some have hit the wall harder than others. These companies all write long-tail liabilities, and have under-priced and under-provisioned for these liabilities.
I believe there are a number of technical insurance threads linking all these failures. This belief is based on analysis of long tail liabilities for numerous global clients that include insurers, reinsurers, brokers (retail and wholesale) and consultants. The most important of these threads is likely to be the phenomenon of superimposed inflation. Another important thread, especially for companies writing relatively low exposures, is high variability. The present report presents a credible scenario in which these companies could have been cash flow positive for many years without actually recognising that their capital was being eroded by superimposed inflation.
Had the long-tail liabilities been evaluated using better statistical and financial tools, it is highly likely that the losses could have been avoided or at least mitigated.
In respect of HIH, the substantial differences between the liquidator’s estimates of losses (liabilities) and the estimates shown in the accounts for year-end June 30th 2000 are more likely to be due to the differences in loss reserving methodologies than any other factor.
The financial markets have experienced a similar chain of events. Some of the world’s largest financial entities (Orange County, Barings…) lost billions of dollars as a result of poor risk management. This triggered a revolution in the methods used to assess market (investment) risks. The various regulatory authorities converged on Value-at-Risk (VaR) as an acceptable measure of risk.
What is needed in the general insurance and reinsurance markets is a revolution in assessing long-tail liability risks that parallels the revolution that is taking place in assessing market risks. However, the revolution in these insurance industries has to reach far beyond that in the financial markets, as VaR, even if soundly constructed, is grossly inadequate as a single measure of risk for long-tail liabilities.
APRA has decided to fast-track general insurance reforms that are vastly inadequate. The proposed reforms are only a small step in the right direction. Statistical quantities such as the estimated mean, standard deviation and 75th percentile of the liabilities are indeed important (provided the estimates are soundly based). However, given the changes in risk assessment currently taking place in the financial markets, it is surprising that the proposed new regulatory general insurance regime does not even mention the concept of VaR. More importantly, these statistical quantities (including VaR) do not in themselves provide sufficient information to assess the financial condition of the company.
In the USA the National Association of Insurance Companies (NAIC) and in the UK the Department of Trade and Industry (DTI) (to a lesser extent) make schedule P data available to the public, for a fee. I believe it should be incumbent on APRA to adopt the American model of collating schedule P loss development data (triangulations) and other relevant data on a yearly basis, for each line of business, for each company, making it readily available to anyone for a fee. This way APRA, rating agencies, brokers and any other organization can conduct their own independent assessment of the adequacy of a company’s provisions as set out in the balance sheet.
It is therefore of concern that the proposed reforms will not result in the best possible framework for monitoring the general insurance and reinsurance industry.
Table of Contents
Section 1 contains a list of reported large reserve increases and failures experienced by various insurers around the world writing long-tail liabilities in the last few years.
Section 2 provides a brief explanation of basic accounting principles for general insurance companies. The relationship between outstanding claims liabilities for long-tail business lines, the inherent variability of these liabilities, and the provision made for them in the financial accounts is explained.
Section 3 describes why general insurance companies can be cash flow positive for many years but as a result of undetected superimposed inflation in their experience (along with high skewness and variability) they suddenly run out of cash.
Section 4 contains a discussion of likely reasons for the problems experienced by the insurers listed in Section 1. These reasons include unrecognised superimposed inflationary trends, skewness and variability of the long-tail liabilities. Deficiencies in the methods used to evaluate risks mean that trends are often recognised too late.
Section 5 explains how early recognition of problems using appropriate probabilistic models can mitigate the losses incurred.
Section 6 first describes some major differences between Life Insurance (LI) and General Insurance (GI) and discusses why deterministic techniques (eg averages) that work well in LI are not necessarily appropriate for GI. We then go on to discuss common (standard) reserving techniques and their shortcomings:
- Failure to adequately identify trends in the paid losses.
- Failure to allow for uncertainty in model parameters of a probabilistic model.
- Failure to adequately allow for process variability.
In Section 7 we explain that the failure of HIH was not just an event that occurred in the last year. In fact, its ‘true’ financial position in respect of its long-tail liabilities was probably little different twelve months ago or even earlier. Arguably its problems commenced when it started writing long-tail liabilities.
The HIH Winterthur Offering Memorandum dated 13 July 1998 is considered in Section 8. In particular, the Memorandum contains significant warning signs as to HIH’s financial health for the informed reader. Yet the public offer was over-subscribed! I first examined the Memorandum in 1998 at the request of a stockbroker. My advice was not to buy.
In Section 9 we provide a likely explanation for the substantial difference in the estimates of losses (liabilities) given by the liquidator and those shown in the HIH accounts for year-end June 30th, 2000.
I believe that the substantial differences between the two sets of estimates is more likely to be due to the differences in loss reserving methodologies than any other factor.
Section 10 explains that ultimately the failure of HIH is likely to be more to do with technical matters than with any corporate impropriety. It is likely that the greater part of the loss could not have been arrested by anyone in the last several years. A major paradigm shift in techniques for assessing long-tail liability risk and reporting them is required.
The revolution in the way the banking and investment sectors assess risk is discussed in Section 11. The concept of Value-at-Risk (VaR) has been developed in response to failures of major financial entities. VaR is an easily understood method for calculating and controlling market risk.
The inadequacy of APRA’s proposed reforms for the general insurance industry is considered in Section 12. APRA has recognised the need for statistical quantities when examining solvency and capital requirements. However, APRA has not gone far enough. The statistical quantities specified by APRA do not include VaR and in any case will not provide sufficient information to enable a thorough assessment of the financial condition of an insurer in relation to its long-tail liabilities. I believe APRA should adopt the American and UK model of collating loss development data on a yearly basis, for each line of business, for each company, making it readily available to anyone for a fee. In this way, APRA, rating agencies, brokers and any other organization can conduct their own independent assessment of the adequacy of a company’s provisions as set out in the balance sheet.