General Insurance Article - GI Insight with Alan Chalk


 Put one sick cow in a big field. Come back later to a random point in the field. You might find a sick cow at that point. Or you might find nothing.

 Now diversify in to all kinds of sick animals. Completely fill the field with unhealthy cats, dogs, and cows and so on. Come back later, to a random point in the field. You will be sure to find a sick animal at that point.

 Some months back, at the start of this column, I promised to look at a deep and meaningful issue - the correct way to react to a large event in the insurance market. Pull out of the market? Jump in with boundless enthusiasm and an increased appetite? Form new companies to take advantage of the “great opportunity”? Companies writing the same business and facing the same event will not all react in the same way. Who is right?

 Leading up to our amazing epiphany this month, we discussed reactions to two types of uncertainty. The first type is uncertainty within our modelled understanding of the world. This is so easy. It is modelled. We knew it would happen. And there is a right answer – credibility theory - although many players in the market still don’t use the right answer.

 Then there is uncertainty when events happen which surprise us slightly but they don’t make us totally rethink our modelled understanding of the world. They were “events outside of the Venn diagram” but we could cope, react quickly and control the outcome. Last month we discussed an approach of how to handle this – optimise your organisation to pro-actively manage uncertainty outside of the box (see last month’s article for details). I am sure it is clear to you that in this situation too, many players struggle to react appropriately.

 Yet there is a third type of uncertainty. When the whole world comes crashing down round your ears and you realise there was something fundamentally wrong with your business or your models. Or both. Although events of the WTC are a well trodden ground, I reckoned that discussing these with some of the underwriters doing business in various companies at the time, would shed light on the various reactions.

 There were three types of reaction.

 Blind panic followed by navel gazing and years of analysis paralysis. Some companies realised that not only had the unthinkable happened (but there was a bomb in the basement of the WTC a few years before?) but their own business practices were both frightening and pitiful at the same time. Some examples:

     
  •   Collecting premium for “no” risk: Consider a building worth $1bn with a Probable Maximum Loss (PML) of $100m. Underwriters who were allowed to expose their company to say $50m of risk, would do so by writing 50% of the first $100m of cover for the building. Then they would expose their company to a further $200m above the PML. Was that not a breach of underwriting authority? Not in their view – since the risk above the PML did not exist! (Draw any parallel you like: Writers of put options; more recent behaviour in the financial markets...)
  •  
  •   Having no idea about the value at risk at the insured location: Many insured items were not allocated to a specific property. These were called “floating sums insured”. The value of the building itself may have been clear. However companies had no idea how much the floating sums insured would add to the buildings value.
  •  
  •   Contract certainty: A well trodden topic – I won’t inflict this on you, only to say that, in some markets, as always, we have massively overreacted.

 When management of certain companies were faced with this litany of woe (and this is only part of the story) it is not surprising that their reaction was just to batten down the hatches, pull out from writing terrorism cover and in general to reduce exposures.

 Blind panic followed by taking advantage of the opportunity

 Other companies took advantage of the shortage of capacity and the hardest market ever to offer terrorism cover with carefully controlled limits at very high prices. These players too will have suffered from all the points above. Despite this, they focused on positive reactions to the event rather than the more negative entrenchments seen elsewhere. I had hoped to attain some deep insight in to how these companies shook off their woes and reacted in the way they did. There seems to be no simple reason, rather a combination of various factors such as:

     
  •   Smaller net losses than other companies
  •  
  •   Agility
  •  
  •   Entrepreneurship

 Setting up a new company

 This is pretty much like the case above. I separate it out only because it is truly amazing how quickly certain key players reacted. In one case they raised $1.7m in a matter of weeks to set up a new company. This takes agility and entrepreneurship to a new level.

 So if you aspire to take advantage of the next upset in the market, check to see if you have the following ability:

     
  •   Will you be able to focus on seizing the day, or will you be too busy navel gazing? If the latter, do yourself a favour now and set up a structure within which some section of your company will be free to take the positive actions needed.
  •  
  •   Are you agile? If not, you are on the way out in any case. So get agile. Now!
  •  
  •   Are you entrepreneurs?
  •  
  •   Add your own items here...

 But were the agile entrepreneurs right? It is so easy to say that they must have been right. Look at the huge (understatement) profit that they made. But no-one knew if al-qaeda would strike again! But actually, yes, they were right. Because, for a change, they were being compensated for the risk they were taking.

 Many insurance companies struggle to make a living by insuring the highest quality risks at cheap prices. Trying to manage the risk out of the equation. The only thing is, that their customers play the same game. They manage the price out of the equation. You can’t fool your customers. They won’t reward you when you are not taking risk. And yes this does apply to private auto too. So these insurance companies diversify, writing more and more slightly underpriced business. Until they have a field of full of sick animals. The only thing that they have achieved is to be absolutely sure that they will make a small (or large) loss.

 Take some true risk. Stop fooling yourself with models. Make a profit. That’s what insurance used to be about. That’s what it can still be about.
  

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