Global explanation for the increase in insurance premiums

Alan Townsend defends insurance price trends and explains how a terrorist attack 5,000 miles away can bump up the cost of your annual household insurance premium

For most, insurance is an unavoidable expense that is hard to feel good about, especially in the light of this year's price increases. The widely held perception is of an insurance industry raking in excessive profits at the expense of Irish businesses and consumers.

The events of September 11th have been used by some to explain the insurance price rises, but how can a terrorist attack in the US possibly have a bearing on the cost of insuring a factory in Cork? This is a reasonable question, worth considering.

The Irish insurance industry is a minnow in global terms. It is a small, open marketplace, exposed to the supply and demand dynamics of the outside world, dynamics that have been quite strained in the past 18 months.

To understand changes in premium rates in Ireland, we need to look at this global system of risk-taking and risk-sharing and Ireland's position in it.

A household insurer writes, say, 50,000 policies in any given year. Assume a policy limit of €200,000 and the theoretical exposure is €10 billion. Quite a large number. Thankfully for the insurer, it would take Ireland falling into the Atlantic for this exposure to be translated into a claim amount.

This insurer estimates that a strong windstorm could cause €30 million of claims on its policies and concludes that this is too large to bear.

Accordingly, the insurer buys some insurance of its own or what is called reinsurance. A reinsurance policy of €20 million with an excess of €10 million means an insurer pays the first €10 million of claims with the reinsurer paying the next €20 million.

The reinsurer will repeat this exercise globally, writing policies for many insurance companies. At some point, the reinsurer itself will have accumulated too much exposure relative to its balance sheet and it too will want to buy insurance or what is called retrocession cover.

And so, an Irish-based insurer becomes part of a chain of security - it places reinsurance with perhaps a syndicate at Lloyd's and reinsurance companies in, for instance, the US and Bermuda. These in turn buy protection from retrocessionaires in say Germany and Switzerland. A big claim from Ireland will ultimately be shared across these five companies in five different countries.

Eventually, the system reaches an equilibrium where, in theory, all the insurers, reinsurers and retrocessionaires have an amount of retained risk and retained premium that is suitable for their capital base.

That's the theory. In reality, things don't work out so smoothly. These companies are operating in a competitive environment, writing policies where, in many sectors, price is the only deciding factor for a buyer.

When there has been a series of years where claims have been low and investment returns on retained premium have been high, insurers can shave pricing and still think they are making a profit.

This can go wrong when the insurers' loss reserves are incorrect (and what they thought was a profit was in fact a loss). For example, claims may take decades to arise under "long-tail" business such as employers' liability insurance. And, for the global insurance and reinsurance industry, this has been going wrong for a number of years.

One needs to appreciate just how long a tail can be. UK-based insurers have just bolstered their balance-sheet loss reserves by hundreds of millions of pounds to cover payments relating to asbestos claims.

These claims are arising on insurance policies written as far back as the 1950s, at a time when asbestos was a common construction material and not known to cause any damage whatsoever. This highlights the level of uncertainty attached to selling insurance - what you did up to 50 years ago can hit your profits today. And asbestos claims have been spiralling in recent years. It is estimated that claims associated with US asbestos exposure ultimately will cost $200 billion (€204 billion). That's $200 billion of claims for which the system received a zero explicit premium.

Plus there are the vagaries of the legal system, particularly in the US. If the court so decides, McDonalds' insurers could find themselves paying claims to obese people suing the fast-food vendors for their overweight condition.

Who could have foreseen this eventuality when pricing an insurance policy? Insurers do try to price in uncertainties such as these in the premium they charge but their backstop position is their reinsurance protection.

Closing the circle, when claims exceed reasonable expectation, whether from extreme events or legacy business written half a century before, then the balance sheet of the global risk system takes a bashing, but especially the retrocessionaires - the buck stops with them.

And, after several years of falling premium and rising claims, the tide was rising.

The terrorist attacks added somewhere between $45 billion and $70 billion, turning a tide into a tsunami. And to highlight the uncertainty, 11 months on, the industry is nowhere near being comfortable as to the final cost of this event.

To replenish their capital, these retrocessionaires increase prices and everyone down the chain suffers, including the Irish insurance company, which in turn passes on the increase to its policyholders.

And this is how an event 5,000 miles away can cause your household insurance to cost more.

What are the prospects for a fall-off in insurance prices for the 2003 renewal season?

When Hurricane Andrew occurred in 1992, costing $20 billion, insurance prices shot up in 1993, insurers made big profits, new capital flowed into the industry, prices began to fall and that's how things continued up to September 10th, 2001.

Can we expect the same pattern now?

Well, prices have shot up and a substantial amount of new capital has already established itself post-September 11th, particularly new start-up operations in Bermuda.

One would expect these to bring downward pressure on pricing but for one factor: the stock market.

Insurers are seeing the asset side of their balance sheets taking a hammering, which is reducing or eliminating profits. They need to keep premium prices up to maintain their balance sheets.

The 2002 renewal season was hard on consumers of insurance - don't expect the situation to be much different for 2003.

Alan Townsend is vice-president, reinsurance, at the Centre Reinsurance International Company, whose IFSC office is the underwriting location for its European operations