A common approach to underwriting distressed risks in the liability space is to apply a higher deductible or excess. This can be across the board i.e., regardless of how the claim arises, or it can be structured so that (say) a higher excess might apply to Worker to Worker claims and a lower one to all other claims. Or a more complex approach might allow a lower excess again to apply to third party property claims.
Higher excesses can be a useful tool for Underwriters. By leaving more losses and/or increasingly significant losses on the insured’s balance sheet they can ‘smooth out’ an Underwriters loss experience. Higher excesses can remove attritional losses from an insured’s loss history and by doing so can allow an Underwriter to significantly reduce the premium they need to charge on a risk. Conversely, on certain risks having an excess set too low can mean an effective ‘money-swap’. In other words, the amount the client pays in premium more or less equals what the insurer pays in claims. This is not uncommon in motor fleets except that the insured still benefits from access to the insurer’s claims service, repairer network etc.
The issues with setting excesses too high can be manifold:
- The insured cannot fund the excess easily or practically at all from its cashflow.
- The insured avoids reporting claims the Underwriter would wish to see reported to avoid a call on the excess.
- While the insured ultimately reports the claim, the notification is ultimately made later than preferable as the insured endeavours to avoid or manage anticipated increases in premium at renewal.
All of these issues can have significant adverse effects for Underwriters. In the first scenario it is, unfortunately, not uncommon for companies in certain occupations to ‘phoenix’ – ie they are wound up and so avoid paying significant amounts of unpaid excesses (which are unsecured debts). Depending on where the excess is set this may not really disadvantage Plaintiffs because their lawyers may simply look to inflate a claim to get past the unrecoverable amount of the excess.
The second and third consequences are related and can have two effects – firstly they can result in the insurer losing the opportunity to settle a claim early and on good terms, and/or to effectively investigate such that they can mount a good defence to the claim. Finally, these claims can skew development factors – when the deductibles are ‘each and every’ and significant (say $500,000) on large attritional books they can mean a significant number of high value claims are not reported to the insurer until very late and when there has been adverse development. This late reporting behaviour skews development patterns such that a liability portfolio may not be fully developed (ie reach 100% of its ultimate reserves) until nine or ten years after the risk or binder first incepted. This stands in contrast to our usual pattern of development where liability portfolios are fully developed at year five or six.
When late development is assumed by actuaries to be the normal pattern it is not surprising that their models will build in an assumption of significant reserve strengthening after 6 years – even if those claims to not ultimately eventuate. That can mean the difference between programs or binders renewing or not renewing.
Using higher excesses to offset underwriting exposures remains a valuable tool for insurers and can also allow insureds an ability to control their claims profile to a greater extent which many welcome. However, they are best used in concert with a sophisticated approach to claims management and a clear notification protocol so that late adverse development can be mitigated and controlled. When Underwriters can work constructively with policyholders and convince them that notifying early and characterises their risk as a well-managed risk rather than a distressed risk the right behaviours can be encouraged. Conversely, Underwriter may adopt a structure where late notification may lead to a higher excess being applied – a strategy that was utilised in the last hard market to encourage the right behaviours.
Artist Credit: Adam Lee