JLT Re VIEWPOINT ENOUGH IN RESERVE?

Transcription

1 JLT Re VIEWPOINT ENOUGH IN RESERVE?

2 3 CONTENTS SECTION 1: RESERVING RELEVANCE... 4 EXECUTIVE SUMMARY SECTION 2: A FRESH PERSPECTIVE... 7 SECTION 3: RESERVING CROSSROADS JLT Re Viewpoint is JLT Re s regular series of reports that comment on or give insight into key topics, occurrences or changes in the (re)insurance and broking marketplace. At JLT Re, our trusted team combines market leading expertise and proprietary analytical tools with the freedom to challenge conventions. We create new insights and explore innovative capital solutions tailored to meet client needs. TOGETHER, WE DELIVER RESULTS Reserving may not be the sector s most exhilarating topic but it could not be more important to insurers balance sheets. Deficient reserves have arguably been the biggest catastrophes ever to have pummelled the (re)insurance sector and empirical data bears this out 1. In fact, it was the liability crisis of which most recently came closest to pushing the insurance sector over the brink. Some will counter that the substantial catastrophe losses of the 1990s and 2000s had a greater effect on sector capital than mere accounting entries on the liability side of the balance sheet. But they forget that several of these events happened in the wake of reserve deficiencies which significantly magnified their deleterious effect on sector capital. The last liability crisis cost the global (re)insurance sector hundreds of billions of US dollars between 2001 and ; dwarfing any one natural catastrophe, or indeed the accumulation of catastrophe losses in any given year. The irony is that this bane of insurers existence has become a boon during the eight years since the financial crisis. Over this period, carriers have released redundant reserves into earnings, thereby compensating for historically low investment yields as well as elevated catastrophe losses. This has encouraged those who argue that the insurance cycle is dead. After all, earnings have been relatively stable over the last eight years, even in an environment of low pricing, low yields and increased insured loss potential. The industry has become smarter is now the received wisdom of many, arguing that actuaries are better than ever at anticipating future reserving trends and pointing to historical evidence that many carriers have been more conservative by maintaining excess accident year loss reserves at 12 months. This JLT Re Viewpoint report examines the validity of this premise and concludes that the sector is once 1 Flandro, David, The Next Big Cat Source: JLT Re Analytics. again likely in a danger phase in which reserves are being released faster than accident year experience would dictate, thereby flattering calendar year profitability. Indeed, the situation today is eerily similar to, if less pronounced, than the comparable phase of 1998 to 2000, with the sector coming off several years of favourable underwriting results and low loss inflation and frequency. By analysing calendar year reserve development by quarter since 1998 for the top 30 global (re)insurance companies and comparing them to accident year loss trends, pricing and previous cycles, the research presented here provides an alternative view of reserving than is commonly used elsewhere. Although today s apparent reserve weakening trends appear to be less extreme than the last, net sector deficiencies are now likely to be closer than they have been to hitting the sector s income statement since the early 2000s. Furthermore, pressure on reserving adequacy is only likely to intensify in prolonged soft pricing environments should historical correlations hold true. The clear implication is that now is the time to seek protection. It is always more economical to purchase adverse development cover (ADC) before deficiency trends are clearly manifest. Fortuitously, reinsurance pricing is at or near period lows in many medium and long-tail lines and cover is more easily obtained than it has been even in the recent past for those with the foresight to move quickly. This piece is a continuation of a series of JLT Re Viewpoint reports which have endeavoured to anticipate industry trends for the benefit of clients. It is hoped that the conclusions herein will empower and embolden reinsurance managers and C-suite leaders to take advantage of reserve protection for the benefit of all stakeholders, especially policyholders.

3 4 5 SECTION 1: RESERVING RELEVANCE The implications of reserving for the insurance sector are difficult to overstate. Loss reserves are normally the largest single item on the right-hand side of balance sheets, and significant reserve development can heavily impact profitability and capitalisation. Reserving practices are under constant scrutiny from key stakeholders, including underwriters, senior managers, investors, auditors and regulators. It is, of course, important to recognise that reserving strategies and methodologies can vary significantly by carrier. Behavioural differences are often related to organisation type (such as public, mutual and private), regional concentration, lines of business and company size. Certainly, the reserving cycle in the P&C industry has been most pronounced for the largest carriers, which are generally competitive public companies exposed to pressures on earnings. The large scale of their operations also magnifies exposure to systemic risks such as the unpredictability of developments in medical technology. ART OR SCIENCE? It therefore follows that reserving is arguably the most critical task for most (re)insurers, especially those with complex, multi-line books of business. Reserving underpins many crucial areas, including pricing, financial modelling and growth strategy, and, in the long-term, usually determines a carrier s success or failure. And yet, the process of reserving is an inexact science as it relies on human judgement to estimate claims that are likely to be paid out in future. There are different accepted methodologies in determining future claims, and carriers use several to estimate reserve levels. The most common are the Chain Ladder and Bornhuetter-Ferguson methods. Both are deterministic as they give point estimates of ultimate claims rather than a range. Other techniques, such as Bootstrapping, are stochastic as they use development triangles to generate a distribution of possible ultimate-claim amounts 3. Irrespective of which technique is used, reserving inaccuracies are inevitable as unanticipated events, such as medical advances, macroeconomic and legal developments and emerging risks, can create a reality drastically different from projected assumptions. THE GREAT UNKNOWN This is especially true for long-tail business such as general liability lines, where claims typically take years to develop. In fact, reserves for some long-tail classes such as product liability can represent, at least initially, multiples of annual earned premiums. Other lines which can be particularly unpredictable include medical malpractice, motor liability and certain specialty lines such as cyber. The challenge of estimating total ultimate losses for long-tail business is shown by Figure 1. Whilst carriers writing short or medium-tail business (commercial multi-peril insurance in this instance) are likely to be notified of virtually all claims after five years, long-tail business (product liability in this example) is still expected to have significant incurred but not reported (IBNR) reserves for future claims after the same five-year period. Figure 1: Total Ultimate Loss Estimates for Medium-Tail and Long-Tail Business After 1 Year and 5 Years % 58% 2 Commercial Multi-Peril 1 year Paid 5 4 Commercial Multi-Peril 5 year Incurred 4 5 Product liability 1 year 19% 49% 3 Product liability 5 year IBNR (Source: JLT Re, SNL) 3 Subotsky, Dmitri, JLT Re "How Do You Square the Triangle?" Insurance Post 1 September 2006.

4 6 7 AN OUTSIZED EFFECT The difficulty of setting aside sufficient funds for unreported claims goes a long way to explaining why deficient loss reserves have historically been the main cause of financial impairment in the insurance sector. Figure 2 shows 4 of impairments have been caused by deficient loss reserves since 1969 whilst rapid growth, arguably just another term for under-reserving, has caused 1 of all impairments. This compares to just for the mega property-related events which feature so prominently in the headlines. A significant number of the reserve-related impairments reflected in Figure 2 occurred during the 1980s and early 1990s when unexpectedly large litigation settlements on asbestos and pollution policies resulted in a surge in claims years after the original policies were underwritten. This led to the asbestos and environmental liability crisis which cost carriers tens of billions of dollars and at one point threatened Lloyd s of London s very existence. Figure 2: Primary Causes of P&C Insurer Impairments 1969 to 2014 Catastrophe losses Alleged fraud Impairment of affiliate Significant business Investment change problems (overstated assets) 8% Miscellaneous 8% Reinsurance failure 1 Rapid growth 4 Deficient loss reserves (inadequate pricing) (Source: A.M. Best) CYCLE CORRELATIONS The late 1990s and early 2000s also saw a wave of impairments when technically deficient underwriting and inadequate reserving forced several companies to go into run-off, including Trenwick, the Independent Insurance Company, Reinsurance Australia Corporation (ReAC) and Alea. This period revealed the strong relationship between reserve development and the underwriting cycle as most carriers overstated rate adequacy between 1998 and 2000, which in turn meant reserves had to be subsequently revised upwards considerably as their inadequacies were belatedly recognised. Such behaviours are often commonplace in soft markets. Conversely, over-reserving generally occurs when business is underwritten at relatively high prices, as was the case in the mid-2000s when carriers became increasingly in some cases irrationally conservative with loss picks after their experiences a few years before. A NEW DANGER PHASE? Fast forward a few years, and (re)insurers have been able to release large reserve redundancies into earnings as it has become increasingly apparent that loss picks for the post liability crisis were indeed too high. However, after more than a decade of favourable development, the pressing question today is: have carriers released the lion s share of redundant reserves built up between 2003 and 2007? Given this obvious question, the reserving cycle is back under the microscope amidst concerns that it has reached an inflection point and some companies are potentially releasing reserves even as accident year experience indicates that redundancies may be exhausted. SECTION 2: A FRESH PERSPECTIVE To help inform the debate, JLT Re has conducted an exhaustive analysis of reserving trends in an attempt to identify any early evidence of net reserve deficiencies. Cedents can secure a competitive advantage by anticipating cyclical changes. This study helps to analyse the sector s reserve adequacy and outlines how carriers can best prepare for a period of potential adverse development. TRADITIONAL RESERVING VIEWS The deterministic and stochastic techniques described in the previous section are all used in accident year analyses 4 which have traditionally served as the basis of sector reserve adequacy assessments. Perhaps the most well-known display is the accident year development bar chart shown by Figure 3. Figure 3: US P&C Accident Year Reserve Development (Bar Chart) 1987 to 2015 Percentage change from initial accident year loss pick (Source: JLT Re, SNL) 4 Accident year refers to the year in which the premiums related to the losses were earned. Losses related to an accident year may develop or be reported during the same year or subsequently.

5 8 9 Figure 3 simply shows the amount of development (with deficiencies positive and redundancies negative) that has taken place for the accident year on the x-axis at the end of the most recent calendar year, in this case year-end The general reserving cycle trend is evident in this chart, with adverse accident year loss development occurring between 1998 and 2002 and periods of favourable development shown before (in the early and mid-1990s) and after (from 2003 onwards). Whilst the simplicity of this presentation makes it easy to compare one accident year s development to another, the analysis must be seen in the correct context. Specifically, the most recent accident years shown are not necessarily comparable to older years, especially for medium and long-tail lines. In fact, it could be argued that the data points for the last three years are not particularly useful as they have had significantly less time to develop. Also, as these percentages are keyed off initial estimates of ultimate accident year loss, changes in reserving practices and philosophy will affect the pattern. For example, if the aggressive initial reserving behaviour of the late 1990s had been repeated in recent accident years, deficiencies, and not redundancies, are likely to have followed. To create a more predictive analysis, development years can be plotted by accident year over a 10-year period, as shown by Figure 4. The lines in this chart show the re-evaluations of the ultimate loss for a given accident year, indexed to the initial estimate that was booked at 12 months (set at 1.00). Lines above 1.00 indicate increasing loss estimates (reserve deterioration) whilst lines below 1.00 represent decreasing estimates (reserve releases) for the accident year on the x-axis. Here, it is possible to see how different years develop at different points in time. The chart shows the cyclical nature of reserving trends over the last 30 years, with an average of six years between the different peaks and troughs in accident years 1993, 2000 and Eleven years have passed since the most recent trough in Figure 4 also seems to confirm the adage that bad years get worse and good years get better. For example, years which began to develop favourably in the early to mid-1990s and mid-2000s have continued to do so. The same pattern is also true for years which were initially deficient. Nevertheless, data for the most recent years have again not had sufficient time to develop, preventing any conclusive analysis around sector reserve adequacy in the near-term. Even so, it is notable that the period of redundancies beginning with accident year 2004 has Figure 4: US P&C Accident Year Reserve Development (Cosine Wave) 1987 to 2015 Percentage change from initial accident year loss pick Figure 5: US P&C Aggregate IBNR Levels 1996 to 2015 Y+10 Y+9 Y+8 Y+7 Y+6 Y+5 Y+4 Y+3 Y+2 Y+1 (Source: JLT Re, SNL) st year IBNR (LHS) Ultimate accident year loss ratio (RHS) Note: Accident year loss ratios from 2006 and prior are shown at 10 years' development. Most recent development is shown for subsequent years (Source: JLT Re, SNL) moderated, with accident years 2007 and 2010 showing no redundancy after their first year s development, and each year from 2005 to 2011 developing progressively less favourably. Although other methods are used to gauge shifting reserving trends, these too have imperfections. The percentage of IBNR assigned at the end of the first year (as shown by Figure 5) can be used as a measure of reserving conservatism and there is a demonstrable correlation between this and ultimate accident year loss ratio development. But this correlation is not so evident when there is no clear IBNR trend, and even less so in less developed accident years. A NEW APPROACH In assessing traditional approaches used to measure reserve adequacy, it quickly becomes clear that all are based essentially on the same information. Put less charitably, all these methods are merely rearrangements of the same accident year data, presented differently. In an attempt to offer a new and more insightful view, JLT Re has analysed reported calendar year reserve movements by quarter since 1998 for the top 30 global (re)insurance companies 5. This proprietary research is not based on historical accident year data, nor is it based solely on any statutory reporting measure. It is, instead, built on detailed research of (re)insurance carriers quarterly, annual and semi-annual filings, press releases and conference calls in addition to statutory disclosures. From these sources, calendar year reserve movements can be uniquely assessed. 5 Calendar year reserve movements by quarter here simply refers to net increases or decreases on prior year loss reserves as reported in any given quarter.

6 10 11 Whilst this method is not without its limitations, its purpose is to augment, rather than rehash, existing research and provide a fresh perspective in understanding how the sector is navigating the reserving cycle. This new view of reserving trends is shown by Figure 6, which plots the simple average of reserve development, where available, for the top 30 global P&C companies as a percentage of equity by calendar quarter (shown by the blue dots). For comparison purposes, Figure 6 also includes accident year loss development for all lines of business (shown by the orange line). Important observations emerge from this analysis. The first is how calendar year reserve movements by quarter have generally been slow to respond to cyclical trends. For example, carriers, on average, released reserves for eight consecutive quarters in 1999 and 2000 even though accident years 1998 and 1999 were, by 2000, manifestly developing unfavourably. An average of 1. of sector equity was released during this time, comprising most of the sector s earnings. Similarly, (re)insurers were still strengthening reserves in 2005 despite significant sector reserve redundancy from 2003 onwards. This serial correlation appears to have continued in more recent years. By extrapolating these trends, fears about a new and challenging phase in the reserving cycle could become reality. Figure 7 highlights this serial correlation with its peaks and troughs since The sector experienced an extreme danger phase during the late 1990s and the result was a period of strengthening in the early 2000s. With a growing number of business lines showing signs of unfavourable development recently (including auto liability in the US where reserves have been developing adversely since 2012), the sector today appears to be in a new, albeit less, acute danger phase. This, of course, has significant implications on carriers financial performance. It also has important repercussions on pricing. Figure 8 shows the strong correlation between calendar year reserve movements by quarter and pricing prior to 2010, with rates increasing in response to reserve strengthening and vice versa. Figure 6: Calendar Year Reserve Development by Quarter for Top 30 Global P&C Carriers Versus Accident Year Reserve Experience Average quarterly calendar year reserve movements as % of equity (LHS) Trendline for calendar year reserve movement Accident year loss experience, all lines (RHS) (Source: JLT Re) Figure 7: Calendar Year Reserve Development by Quarter for Top 30 Global P&C Carriers and Reserving Cycle Phases 14 Strengthening phase Overreaction phase Danger phase New danger phase? 8 - Windfall phase - 7 Average quarterly calendar year reserve movements as % of equity (LHS) Accident year loss experience, all lines (RHS) (Source: JLT Re) Figure 8: Calendar Year Reserve Development by Quarter for Top 30 Global P&C Carriers and Insurance Pricing Trends Average quarterly calendar year reserve movements as % of equity (LHS) Workers comp pricing (RHS) General liability pricing (RHS) Commercial property pricing (RHS) D&O pricing (RHS) Umbrella pricing (RHS) (Source: JLT Re, Council of Insurance Agents & Brokers, Barclay s Research)

7 12 13 The period between 2010 and 2012 saw increasing rates accompanying reserve releases, suggesting underwriters behaviour may not have been consistent with reserving reality. Since 2012, pricing has moderated but past correlations indicate this may not last long if sector reserves become deficient on a net basis. EXPLORING THE EXTREME Analysis of calendar year reserve development can be extrapolated further by drilling down into different lines of business. This is attempted by creating composites of known market leaders for specific business lines. Whilst it is acknowledged this process is not without its limitations and can only serve as proxy, the results offer interesting insights that are unique to individual lines of business. JLT Re has provided two such examples in Figures 9 and 10 for US workers compensation and UK general liability business. Both charts compare the simple average of reserve development by quarter for companies that have significant market shares in each line of business, along with respective accident year loss experiences. The danger phase in the late 1990s is particularly striking for the workers compensation composite as Figure 9 shows carriers released reserves for 11 consecutive quarters between mid-1998 and the end of Unsustainably cheap reinsurance exacerbated the situation during these years, best exemplified by the Unicover Pool in the United States (some of which ultimately had to be unwound). This coincided with accident years developing unfavourably, thereby explaining how under-reserving within workers compensation lines was a major contributor to the liability crisis that followed in the early 2000s. Indeed, an average of 3. of carriers equity was used to strengthen reserves at the height of the crisis between the first quarter of 2001 and the fourth quarter of Reserve strengthening for the workers compensation composite continued well into 2006, several years after accident year development had trended towards redundancies, Figure 10: Calendar Year Reserve Development by Quarter for UK General Liability Composite Versus Accident Year Reserve Experience Average quarterly calendar year reserve movements as % of equity (LHS) Accident year loss experience, UK general liability lines (RHS) Trendline for calendar year reserve movement (Source: JLT Re) Figure 9: Calendar Year Reserve Development by Quarter for US Workers Compensation Composite Versus Accident Year Reserve Experience Average quarterly calendar year reserve movements as % of equity (LHS) Trendline for calendar year reserve movement Accident year loss experience, US workers comp lines (RHS) (Source: JLT Re) indicating a protracted overreaction phase. A brief danger phase emerged between 2010 and 2013, prompting a significant increase in workers compensation pricing during this time. Trends in more recent years are less conclusive, although there have been notable instances of reserve strengthening for medium and long-tail business over the last year as pricing has fallen back into negative territory. Similar trends are also visible in the UK general liability composite (shown by Figure 10), albeit on a less exaggerated scale. A more moderate danger phase is evident in the late 1990s, and after significant strengthening between 2001 and 2003, reserve development loosely followed accident year loss experience during the mid-2000s. Evidence of reserve weakening re-emerged between 2009 and 2014 as calendar year development trends and accident year experience diverged. Price discipline followed to offset the impact. As with US workers compensation, recent years offer less insight, although a trend towards fewer reserve releases is clearly evident from Both the workers compensation and UK general liability composites show that reserve development is not solely driven by earnings pressure and competition within specific regions or classes of business. External factors, such as macroeconomic developments and medical utilisation, can be equally influential on reserving cycles. Whilst global (re)insurers are most exposed to these risks, they can affect all carriers, whether they are regional, national, monoline or mutual companies. Now is the time for cedents to consider reserve protection as cover can become difficult to execute after the reserving cycle is perceived to have shifted unfavourably.

8 15 14 SECTION 3: RESERVING CROSSROADS Reserving levels are always under close scrutiny and this is especially true today as many carriers continue to release reserves to protect or enhance profits in an environment of low (re)insurance pricing, stagnant premium growth and lacklustre investment returns. This is happening even though it is once again becoming clearer that the reserving cycle is at an inflection point. The correlation between pricing levels and accident year reserve adequacy is equally as important. Whilst cause and effect can sometimes interchange, rate softening in the (re)insurance sector is likely to be applying significant pressure on accident year reserving and overall adequacy trends. The sector has historically used two or three different approaches to assess reserve adequacy, all of which rely on accident year development data. Whilst these have proved (and continue) to be useful, all have limitations. The global calendar year reserve development study conducted by JLT Re is an endeavour to supplement and complement these techniques by looking at historical and emerging trends in order to understand the future direction of travel and to help carriers prepare for early signs of systemic adverse development. For insurers with long-tail exposures, this backdrop points to the value of reinsurance solutions. These transactions can take many forms, including ADCs, loss portfolio transfers and reinsuranceto-close deals (for Lloyd s syndicates). Freeing capital tied up in loss reserves can enable companies to enhance capital management strategies and to improve capital efficiency. Furthermore, rating agencies typically look favourably on such protection which can help enhance competitiveness, particularly in commercial lines. Having such protection in place can also help support a firm s valuation in negative reserving cycles. This analysis implies that the sector is experiencing another danger phase, albeit potentially a milder one than in the late 1990s, in which carriers are continuing to release large amounts of reserves even as accident year experience indicates that redundancies are fast diminishing. Indeed, there have been some notable instances of reserve strengthening in recent quarters. Now is the time for cedents to consider protective covers as they can become difficult to execute after the reserving cycle is perceived to have shifted unfavourably. JLT Re exists to deliver these solutions. By continuing to bring such important trends to the fore, JLT Re is uniquely placed to inform the discussion and deliver the most innovative solutions to our clients.

9 16 CONTACTS David Flandro Global Head of Analytics London +44 (0) Keith Harrison Chief Executive Officer UK & Europe London +44 (0) Julian Alovisi Head of Research and Publications London +44 (0) Ed Hochberg Chief Executive Officer North America Philadelphia Isabella Gaster Head of Communications and Marketing +44 (0) Stuart Beatty Chief Executive Officer Asia Pacific Singapore stuart.beatty@jltre.com UK & Europe North America Asia Pacific Middle East Africa This publication is for the benefit of clients and prospective clients of JLT Re. It is intended only to highlight general issues that may be of interest in relation to the subject matter and does not necessarily deal with every important topic nor cover every aspect of the topics with which it deals. The information and opinions contained in this publication may change without notice at any time. If you intend to take any action or make any decision on the basis of the content of this publication, you should first seek specific professional advice and verify its content. JLT Re is a trading name and logo of various JLT reinsurance broking entities and divisions globally and any services provided to clients by JLT Re may be through one or more of JLT s regulated businesses. JLT Re is a trading name of JLT Reinsurance Brokers Limited. Lloyd s Broker, Authorised and regulated by the Financial Conduct Authority. A member of the Jardine Lloyd Thompson Group, Registered Office: The St Botolph Building, 138 Houndsditch London EC3A 7AW. Registered in England No VAT No _09.16