Tip of the Iceberg?
The recent high-profile announcement by QBE has prompted us to set down some thoughts on reserving and capital issues raised here. An open question, outside the scope of this article, is whether, it signals the first concrete sign of an approaching wave of soft-market bad news in the sector.
Reserves are inherently uncertain
The first point to make relates to the size of QBE’s reserve strengthening, estimated at $650 million this year. In the context of 2012 year-end outstanding claims reserves of approximately $18 billion, a 3-4% movement feels to us to be well within the bounds of what we would expect to arise from time to time. This is supported by QBE’s accounts which identify a reserve margin of $1.3 billion which translated to an 88% level of confidence. As a result, it is hard to see that this deterioration is likely to represent significantly more than a 1 in 4 or 1 in 5 return period scenario. We will return to the topic of reserve margins later in this note, however as the world moves inexorably towards greater disclosure of best estimate reserves and held margins, investors must take steps to ensure that they understand the deep philosophy each company applies to its valuation of liabilities.
Reserving Program business needs a differentiated approach
QBE’s prior accident year claims development of $650 million included a second half charge of $470 million. Of this, the largest part arose from $300 million of North American Program business (particularly in relation to long tail classes of business such as workers’ compensation, general liability and construction defects risks). The remainder arose from $170 million of other divisional portfolios.
It is not our place to comment on the specifics of what has arisen at QBE, however managing US Program business, where a company “gives its pen away” in one of the world’s most competitive markets, requires a differentiated approach from mainstream business.
In our experience, there are a number of relatively basic requirements that insurance organisations need to follow in order to make a long-term success of such arrangements. These include:-
- Ensure a regular actuarial analysis of the underlying rating plan. This may sound obvious but requires good data and a regular flow of detailed information from the cover-holder to the insurer. If the cover-holder cannot provide the data to you – be warned!
- The actuarial analysis should address the loss-cost by broad rating-factor and make appropriate allowance for large and catastrophe losses. Explicit allowance for expenses and capital costs make up the balance of the technical premium. Monitoring actual premium to technical premium should give a first indicator of the profitability of the book either in total or by specific sub-segments.
- Whilst an actuarial analysis can act as a first line of defence, it must be boosted by the actuary working closely with the underwriters and claims personnel to identify trends and other policy conditions that can impact the actuarial assumptions. This is particularly important for longer-tail lines.
- To make program business work properly and in order to provide comfort to management about its performance requires a lot of regular and technical data from the delegated underwriter. Some rating plans require state approval. For these, it is important to build in as much flexibility as possible in underwriter adjustments. One exercise we have found useful is to review competitor rating plans, as these can prove instructive.
- Alignment of interests. It is essential to get these as close as possible together. Never forget it is the insurer’s stake and, generally speaking, as capital provider they have more downside than upside risk in the arrangements. If it is in the interests of the cover-holder to write more business independent of the profitability, this is what they will do.
In summary, unless firms can get the quality of data to perform sufficiently robust, timely and granular actuarial reviews of these portfolios, they will find that they will come unstuck.
QBE also announced that their US Crop business has suffered a combined ratio at 11% above plan. This is attributed to a collapse in crop prices after early-season preventative planting claims eroded the Federal Crop Insurance Corporation reinsurance deductible.
Inevitably across a portfolio of business lines, some lines will suffer adverse experience whilst others outperform. Even for a significant portfolio as here (US crop is a significant line to QBE at around 8.5% of GWP), it is hard to be too concerned that this is symptomatic of anything more than the volatility of this class. Two interesting points raised, however, are these:
- To what extent should technical premiums allow for the unknown potential impact of climate change? Clearly this is an area of emerging science, however we think some scenario analyses will be helpful in forming a view on the systemic hits that could affect this class.
- When and how should firms recognise losses where underlying deductibles have been eroded early in the year? Clearly the risk of loss is greatly increased in such an event, so from a statistical perspective projected losses should be increased even though no claim event has arisen. This is certainly one area that audit committee’s should be checking on and discussing with their auditors. Furthermore, with Solvency II back on the agenda, how these issues are handled in the technical provision calculations need to be thought through.
Catastrophe retentions are going up; how should share prices respond?
QBE have announced that they are increasing their retention by A$100m, making significant cost savings as a result. A few weeks ago, RSA was punished by shareholders for suffering greater than expected losses from the St Jude’s Day storm as a result of having increased their retention. This raises the question for us as to how firms are expected to get the question of retention right.
Unfortunately, it seems that firms will be judged on such calls with the benefit of hindsight, so perhaps there is no right answer to the question of how much and at what level firms should buy reinsurance. There are a few approaches that firms could consider to help manage this communication process:
- Managing aggregates and buying enough top-level protection to mitigate the cost of “killer scenarios”, those most extreme outcomes that will otherwise impair the business. Models of such outcomes will, almost by definition, never be able to predict sufficiently reliably the worst outcomes that might arise; prudence is therefore paramount.
- Communicating to shareholders, in advance and in sufficient detail, the possiblility of specific events to impact profits, and the uncertainty factors that affect these estimates. This is not only difficult technical work, but also a challenging disclosure to make in a manner that does not expose firms to litigation should these forecasts prove incorrect. Giving context such as the modelled 1 in 100 and 1 in 250 for various events in various exposed regions can provide useful benchmarks to readers.
- Exploring and presenting the consequences to profits of multiple major losses as well as solely the result of large individual events. Often relatively minor changes in modelling assumptions can have a material impact on the consequences of retention changes and capital requirements.
How meaningful are reserve margins?
The final theme in the QBE announcement relates to an increase of $200 million in the risk margin over the central estimate (now 9.0%, up from 7.6% in June) to achieve a probability of adequacy of 90% up from 88% as at June.
We think that such numbers need to be interpreted very carefully, not because they are flawed, but rather because the actuarial theory behind modelling reserve uncertainty continues to develop, and there is a wide spectrum of practitioner views on the adequacy of some approaches. Our view is that (in an interesting insurance analogy to the limited value that banking models based on daily VaR measures provided in forecasting extreme tail risks), triangle-based statistical techniques used to evaluate reserve uncertainty need to be treated with particular care.
Stakeholders therefore need to ask probing questions about how these percentiles have been obtained, what they really represent and how they extrapolate into return periods such as 1 in 10 and beyond. From personal experience, we think firms must operate two concurrent approaches to make a reasonable determination of the reserve distribution.
- A statistical or quasi-statistical process is necessary in order to make sure that the result is objective and provides a meaningful quantitative measure.
- A scenario-based deterministic assessment based on expert input from claims and underwriting specialists, together with a flexing of key actuarial assumptions. This ensures that the estimates remain anchored in reality, and include a sufficiently prospective view of risks to reserves and links the reserve estimates to underlying drivers.
This two-legged approach provides the advantage of enabling assumptions to be challenged and explored whilst enabling the actuary to have a much better insight into reserve drivers.
Is the QBE announcement a harbinger of the effects of intense competition in the property & casualty industry? If it is, as a number of forecasts now state, two areas of focus retain central importance:
- Robust and widespread technical pricing, particularly in unforgiving delegated authority markets;
- Clear communication to external stakeholders of uncertainty in the balance sheet and prospective income streams as the business navigates these dangerous waters.