A Look Back on 2006

01 November 2006

Colin Croly, Barlow Lyde & Gilbert

The first point make about the global reinsurance industry is that it is doing well. According to Standard & Poor’s, most reinsurers have sound balance sheets and good earnings momentum. Many are in a healthier financial position than they have ever been. That the industry was able to cope with the catastrophic losses of 2005 is a tribute to its robust strength. 

After 9/11, new capital flooded into a rapidly hardening market, leading to a host of new start-ups: the ‘Class of 2002’. After Hurricanes Katrina, Rita and Wilma entrants to the market introduced around US$27 billion of capital. The main question now is whether all this new investment will lead to softening of rates as the 2006–2007 renewal season gets into full swing. At least for now, there is more talk of underwriting discipline than of growth and market share, but it remains to be seen if this time round there will be any significant smoothing of the usual insurance business cycle. If rates do soften, many will find it hard to resist the temptation to defend or increase market share. 

So where has all this new capital gone? Of course, much has gone into new startup reinsurers and Bermuda continues to attract considerable investment. Not only is the tax regime favourable but, perhaps more importantly, companies can be established quickly to take advantage of a hardening market. With all the hype about Bermuda, it’s easy to forget that London has also benefited from a substantial proportion of additional capital. Much of this has also gone into alternative market structures, the most popular of which have been ‘sidecars’ and catastrophe bonds. Hedge funds and private equity funds, eager to diversify, have played a major role in funding these new entities and structures and 2006 saw a continuation of the ever increasing effect of the capital markets on the insurance and reinsurance industry. Today, the two are more closely aligned than they have ever been. 

Another global trend has been the increasing role and sophistication of rating agencies. Fortunately, there have been less downgrades in 2006 than occurred during the previous couple of years. The French reinsurer Scor has actually been upgraded. The rating agencies have also begun moving away from their traditional historical databased models towards a more risk-based analytical approach. It seems clear that as financial markets grow more complex and interconnected, investors and counterparties will continue to demand more transparency as well as independent opinions about the creditworthiness of those with whom they do business. Nevertheless, the power wielded by the rating agencies remains a source of concern to many in the market. 

Regulators have also been having a greater impact. In the UK, the continued development of the regulatory regime and the Financial Service Authority’s increasing enforcement actions have attracted considerable attention. Debate continues as to whether the regulatory regime enhances or detracts from the UK market’s overall competitiveness. Although the FSA continues to herald its ‘light touch’ principle and riskbased approach, dealing with regulatory issues still seems to occupy an inordinate amount of the time of insurance and reinsurance professionals. This debate is certain to continue. 

During 2007, there are likely to be further developments arising from the European Commission’s investigation into the business insurance market. Over the last year, many in the market will have been responding to questionnaires received from the Commission, whose original intention was to produce a report on the outcome of the enquiry by September 2006. At the time of writing, this is still awaited. It remains to be seen whether anti-competitive practices will be found. It’s probably fair to say that many in the market remain uneasy that the Commission will fail to fully understand the unique nature of the London subscription market and the business practices it entails. 

One issue which perhaps slipped down the agenda in 2006 was broker transparency and the impact of the allegations made by New York State Attorney General Eliot Spitzer. Clearly the disclosure demanded of the broking community as a result of the Spitzer probe was a wake-up call to the market. This is an issue which may raise its head again in 2007, particularly in view of the London Market Association’s recent call for the FSA to take a closer look at broker remuneration and the disclosure provided to clients. 

Reform of business practices has remained a critical issue in 2006 with contract certainty at the top of the agenda. In the UK, the FSA requires that by the end of 2006, 85 per cent of insurance contracts must be compliant: ie, with all contractual terms clearly agreed before coverage starts. The good news is that with the FSA’s deadline rapidly approaching, the International Underwriting Asociation has recently reported that more than 90 per cent of policies written by IUA member companies already meet its contract certainty targets. The bad news is that contract certainty is no guarantee of contract sense. Careful drafting remains as vital as ever. There is also now much greater focus on claims-handling processes with more and more insurers and reinsurers laying down exacting service standards and key performance indicators. 

There have been a number of significant legal developments over the past year. Perhaps the biggest relief to the reinsurance market was the upholding of a flood exclusion by a US district judge in Mississippi. Insurers sought to deny losses caused by a combination of wind and water on the basis of express exclusions for wind-driven water damage or flood. The judge held that the exclusions were effective to preclude recovery in relation to damage caused by flood, even if the flood was in turn caused by Hurricane Katrina’s winds. Although this decision was hugely welcome for insurers and reinsurers, it is only the first of hundreds of wind-versus-water disputes expected to be heard in US courts. 

Many in the market are still struggling to cope with the numerous claims arising from Hurricanes Katrina, Rita and Wilma. These claims have placed a huge strain on insurers and reinsurers. There are numerous potential issues, many of which could take years to resolve. There are complex causation issues relating to whether losses resulted from wind, flood, bursting levees or something else. There are concerns that some claims are being settled prematurely, or under political pressure, and not in accordance with policy terms. This raises potential reinsurance issues, particularly in the absence of a strong ‘follow settlements’ clause. Complex aggregation issues are also likely. Most catastrophe excess of loss policies will contain an hours clause which provides a definition of ‘loss occurrence’. Typically, this will allow the aggregation of individual insured losses caused by an ‘event’ only if the losses were caused within a given time frame: usually, 72 hours. By way of example, this may make if difficult to aggregate losses resulting from Katrina’s first landfall in Florida with losses flowing from her second landfall in Louisiana. 

Any settlements reached at a direct level will need to be handled with considerable care. Settlements have been in particular focus this year, following the Commercial Court’s decision in Enterprise Oil v Strand Insurance. To appreciate the significance of this decision, a little background is required. In the 2004 decision Lumbermens v Bovis Lend Lease, Bovis settled a claim and counterclaim with a client, but failed to identify in the settlement the precise value of its legal liability. When it claimed on its indemnity insurers, it sought to adduce evidence from its solicitor as to what its liability had been. The judge in Lumbermens did not allow this. It was held that the lack of a specific figure meant that there had been no ‘ascertainment’ of Bovis’s liability, as required under the terms of its policy. Evidence from the solicitor might not be used to salvage the situation. The more recent decision in Enterprise Oil has cast significant doubt on Lumbermens. Indeed, the judge in Enterprise Oil said he simply did not agree with Lumbermens. Although Lumbermens has not been overruled (only the Court of Appeal could do that) it would appear that a failure to identify a precise sum as referable to a particular claim or cause of action is not necessarily fatal to a reinsured’s ability to recover on its reinsurance. Nevertheless, this remains controversial and is almost bound to be an issue before the courts again before too long. In the meantime, insurers reaching global settlements that do not provide precise sums referable to specific causes of action, need to take particular care. 

Another significant decision this year was the outcome of the Aon 77 (Bonner v Cox) litigation. In this case, the court grappled with whether, in an excess of loss reinsurance contract, a term should be implied to the effect that the reinsured would conduct its business ‘prudently and reasonably carefully in accordance with the ordinary practice of the market’. The court held that in the context of nonproportional business, where the reinsured and the reinsurer had competing interests, and one would profit at the expense of the other, there was nothing to support the implication of such a term. The court would not therefore intervene to protect a reinsurer from the consequences of its own imprudent underwriting. The position is different in proportional reinsurance where such a duty has been held to exist (Phoenix and Halvanon (1987)). 

Looking forward, perhaps the biggest question for 2007 is whether the reinsurance market will begin to soften. Much of course will depend on the outcome of the 2006 hurricane season which, at the time of writing, appears to have been relatively benign. Nonetheless, climate change looms large as an issue for 2007 and beyond and this may well have a permanent impact on the reinsurance market, particularly US catastrophe business. The volatile nature of the catastrophe market has led to massive rate hikes, but still there is a shortage of reinsurers willing to write this class of business. 

More generally, the continuing involvement of the capital markets and the increasing range and sophistication of products available is almost bound to continue. Likewise, the role and influence of the rating agencies and regulatory authorities are here to stay. Solvency II, the EU’s review of its insurance directives, and the new risk-based capital adequacy regime will be at the fore in 2007. In the UK, the Financial Services Authority has signalled its willingness to encourage the establishment of insurance special purpose vehicles and, assuming this gets going, this could herald the beginning of an exciting range of new structures and products. Sidecars and SPVs will require regulatory approval as well as careful documentation and, as usual, new opportunities will create new risks. 

Significant changes may also be on the way to English insurance law. On 18 January 2006 the UK Law Commission invited comments on which areas of insurance contract law should be reviewed with an eye to possible reform. It proposes issuing a consultation paper during the first half of 2007. Clearly, significant and long-established parts of the law are susceptible to reform, including the law relating to non-disclosure and breach of warranty. The market might have just cause to complain if the achievement of contract certainty is followed shortly thereafter by an overhaul of English insurance law.

It is not possible to buy entry into Who's Who Legal

terms and conditionscontact us