The America International Group Inc. (AIG) is one of the most reputed global insurance companies currently providing their services in more than 80 countries all around the world. The insurance sector marketing arm is known by the name AIG which deals with international businesses and individuals in the different class of business namely property, casualty, life and retirement and general insurance.
In the UK, the life insurance arm of the company is promoted as AIG Life Limited providing cover for individuals, their families and businesses alike. The organization is authorized by the Prudential Regulation Authority and is jointly regulated by the Prudential Regulation Authority and the Financial Conduct Authority in the UK.
According to the definitions available at online sources of IRMI, in the context of the insurance sector, class of business refers to the industrial categorization based on the coverage provided by the insurer and the exposure to risk. The categorization according to the class of business is to group homogenous risks in order to facilitate rate development for underwriters (Irmi.com, 2018). In this assignment, the focus will be made primarily upon the casualty class of business in the context of the AIG insurance group in the UK. In this class of business in insurance, various liabilities are covered while AIG provides coverage of liabilities across diverse classes of businesses in the UK. In this particular assignment, the focus will be made specifically up on the professional liability insurance subclass offered by AIG in the UK in order to effectively evaluate the reinsurance programs for AIG, current position of the underwriting cycle for the casualty class of business in AIG, impact of the underwriting cycle for the liability/casualty class of business on the reinsurance program and making appropriate recommendations with the aim of optimizing the reinsurance program for AIG UK.
Explanation of the reinsurance program for liability/casualty class of business
Insurance products sold under the liability/casualty class of business generally cover for any claims made against the insured business or individual by any third party for any damage or loss that they have incurred as a result of the actions of the insured. There is a diverse variety of subclasses of this particular class of business which are offered by AIG in its UK operations but for this assignment, we will consider the Professional Liability Insurance (PLI) by AIG. Thus this section focuses on the key characteristics of the reinsurance programs available for AIG specifically in the context of the aforementioned class of business.
AIG UK offers Professional Liability Insurance for all types of professional practices including sole traders to large multidisciplinary organizations from various areas like accountants, insurance brokers, employment agents, solicitors and engineering & management consultants to only name a few. Insurance companies are required as a legal obligation to ensure that sufficient funds are retained so that they might be able to pay off all potential future claims made by the insured clients of the business. Inherently this allocated amount is significantly large in most cases and it is only a rare event that all the insured clients of an insurance company, AIG UK, in this case, will place their claims at once. But if they do so, for example in the case of a climatic catastrophe, the insurance company has to make sure that the required capital is always on hand as a mandate. Therefore, insurance companies seek to reduce some of these responsibilities by means of insurance for them and this is where reinsurance comes into play. A reinsurer is thus another insurer who is transferred the risk by the insuring company.
A reinsurance program not only reduces the mandatory amount of capital that the insurance company is required to hold in order to provide coverage but also helps to optimize loss experience for the insurance company while generating more predictable financial results for the insuring company.
The casualty insurance division of AIG under the general insurance unit has been reporting a combined ratio of 103.8% in 2018 which is deterioration from 99.8% during the same time in the previous year. According to the CEO of AIG, cutting expenses and rebalancing the book of liabilities are of key importance to the profitability. In this context, therefore, the insurance company is aiming to buy more reinsurance coverage in order to effectively manage the volatile nature of the business.
Currently, the organization is engaged into an enormous reinsurance contract with National Indemnity Co (NICO), a subsidiary of Berkshire Hathaway which provides reinsurance and covers 80 per cent of AIG’s pre-2015 long tail commercial liability exposures above $25 billion and with limited reinsurance coverage of $20 billion. While the insurance company reserves the discriminatory rights to handle and resolve claims, the reinsurer, NICO also reserves some consultation rights.
AIG is set to pass on a major share of its significant loss experience to capital coverage from its existing reinsurance coverage in the second half of the current year since it has already used up a major portion of the retention in the most recent quarter. Catastrophe losses were estimated to amount up to $150 million while non-catastrophe losses have been estimated to be amounting to more than $10 million to AIG in the second quarter of the current financial year. These will be covered net of reinsurance for AIG toward which the organization is currently looking forward to limiting severe losses in the second part of 2018.The currently existing reinsurance coverage for AIG while expected to limit the losses to the insurance company in 2018 is also deemed to share the losses to capital market investors as the reinsurance program under which AIG is covered includes participation from capital market investors like ILS funds. The expected coverage in the second quarter of 2018 might be the aggregate reinsurance cover or a new reinsurance cover which can protect the insurance company against severe losses. The analysis suggests that the presumed stop-loss protection will be covering as the severe losses faced by the company hits the $415 million mark in the second part of 2018. This severe loss amount combined with the already pre-existing $293 million, is a major reason why AIG is looking forward to its reinsurance programs to cover for the estimated losses in casualty class of business in 2018.
A brief description of the current position of the underwriting cycle for liability/casualty class of business
The Underwriting cycle or insurance cycle fundamentally indicates the deviations in the insurance business calculated over a fixed time period. While underwriting cycles extend for years, this time period can range from two to ten years depending on the market trends and as the market conditions for the underwriting shifts from soft to hard and again from hard to soft.
As identified before, the peaks and troughs of the underwriting business in the oscillating hard and soft market is represented by the underwriting cycle. At the initial stage of the cycle, the business market is soft as a consequence of rising competition and excessive insurance capacity. This forces insurers to lower their premiums for selling their insurance products. A sudden and mass increase in the number of insurance claims made by the clients of different competing insurers in a market will make the smaller organizations insolvent and drive them out of the market. This soft market scenario leads to the decrease in the number of competing for insurance businesses in the market as well as generates a market for lower insurance capacity that is feasible for underwriting for the insurance companies which survive the situation. Therefore, for a brief period of time, these surviving insurance companies can increase their premiums in order to realize increased revenue growth. As the existing insurance claims are cleared off by the surviving insurers in the market, the profitability of these existing insurers’ increases with the revenue growth resulting from higher premiums. As the market stabilizes and new clients are generated over time, competition starts to rise once again as new insurers enter the market attracting new clients with lowered premiums and offering flexible requirements in order to capture the market in a short time period. This leads to the surviving insurance companies who have been functional to adjust their pricing and premiums more competitively in order to be sustainable and the underwriting /insurance cycle starts all over again.
According to Craig English, Senior VP and director of Property & Casualty Insurance, PSA, in 2013, the UK market was envisaged as a hard market due to a string of natural catastrophes and as a direct implication of residual effects of the economic downturn. 2011 was identified as the year with the most numbers of natural calamities which led insurers and reinsurers to suffer tremendous losses. Premium rates had escalated as the insurance carriers made a significant return on investments while this had been limited to three to five per cent ROI during the same period.
As the underwriting cycle has progressed or more accurately oscillated in the opposite direction, Stephen Netherway looks at the 2018 insurance market to be soft in nature. This has been attributed to one of the most important elements of the underwriting cycle, the rates. In the UK underwriting scenario, 2017 exhibited tremendous catastrophic losses impacting the reinsurance market significantly demanding trade-offs between increased retentions and decreasing reinsurance costs (Insurance Edge, 2018). According to PWC UK reports, as a result of the 2017 natural calamities, the rates of the premium could be hiked by London Market.
As per the review of the market generated by PWC UK, the London market insurance firms had forecasted price drop at the rate of 1 to 2% prior to the surge in insurance claims made after the catastrophe. This was a direct extension of the soft market slide. However, post the natural calamities in 2017 which led to the surge in the number of insurance claims and as a result of which the market started to harden at the rate of premium price hikes at around 3 to 4%. Post-2017, these anticipated price hikes of the premiums are deemed to increase according to the reports of PWC UK.
Even though the underwriting cycle turn in 2018 with an increase in pricing and rates is welcome, it is still not comparable to the likes of the turning of the underwriting cycle in UK post-2005 catastrophes. This has been largely attributed to a market which has delivered a creditable 7.2% mean value for ROI for the last five years and 9.2% in the last ten years. As a result, the market continues to attract new clients and subsequently, the new capital.
Even though the expected price hike post-2017 are anticipated by existing insurers in this turn of the underwriting cycle, the currently prevalent, flat underwriting cycle is likely to exhibit a gradual return on the investments which will take a long time. Therefore, for sustaining long-term returns, it is necessary to refer to the significance of the underwriting discipline (the class of business which is in this case, casualty insurance offered by AIG UK) and implementing efficient capital management for cost control. Therefore, the current underwriting position which is focused upon the pricing strategy and its anticipated upturn as a result of the periodic transformation from a soft market to a hard market and vice versa exhibit the inherent necessity to shift the focus on to the basics.
This is evaluated furthermore from the performance of the Lloyd’s, one of the most significant competitor of AIG UK who exhibited a combined ratio of 114% during the last financial year while other peers exhibited better ratios under the margin of 100 per cent.
Analysis of how the underwriting cycle, for liability/casualty class of business, could influence the reinsurance program
As envisaged before in the previous sections of this document, AIG UK’s reinsurance program is facilitated by NICO, which is a subsidiary of the Berkshire Hathaway Inc which offers a $25 billion coverage to the insurance company thereby sharing the responsibility of reserving funds for the policies that are offered by AIG to its clients. The reinsurance program covers 80 per cent of AIG’s pre-2015 long tail commercial liability exposures above $25 billion and with limited reinsurance coverage of $20 billion. However, in the context of the currently existing underwriting cycle which is prevalent for the casualty insurance class of business of AIG, the anticipated turn of the cycle as the insurance market oscillates from hard to soft in 2018, it can be envisaged that the underwriting cycle has certain implications up on the reinsurance programs of the insurer AIG, UK.
The effects of the underwriting cycle can be rightfully explained in the light of an analogy between AIG and a geared investment trust. In this analogy, the premiums that are reaped represent borrowed funds. As the market tends of getting softer post the catastrophe in 2017 which witnessed a hard insurance market in the UK, these borrowed funds are impacted as the softer market will inherently lead to the hike in the cost of borrowing. Profitability per unit of borrowed funds is anticipated to be squeezed under the currently existing underwriting cycle attributed to the softer market and as such, it can be envisaged that there will be no correlated or anticipated changes in the return on investments (ROIs). In an ideal situation, this will lead to the insurer, AIG to become more variation averse. Subsequently, anticipated profitability will be low which will lead to further reduction of the acceptable downside. In order to reduce the variation averse, therefore, the option that is left to the insurer is to re-evaluate their reinsurance programs and as such the retention policies.
In order to cope with the situation and with the fundamental aim of enhancing the short-term profitability of AIG as a measure to tackle the lowering of unit profitability, the insurer may cede business at unprofitable rates for the reinsurer NICO. However, this will also mean that in the long run, AIG will have to pay the reinsurer at a more unprofitable scenario in the future when the reinsurance policy of the insurer is deemed to be penetrated by the end of 2020. The only feasible option to tackle this situation in the future such that the payback will not affect the profitability of the insurer in the future is to propagate business in a direction that will facilitate the payback to happen at a time when the insurer has achieved the targeted rates of per unit profitability in terms of the borrowed funds as depicted in the aforesaid analogy. Therefore, the aforementioned situation of adjusting the unit profitability will affect the reinsurance program and the retention.
Pertaining to the insurance market of London and the UK in general, the paradigm exhibiting softer rates of premium at the bottom of the underwriting cycle while at the same time prevalence of the scope of the availing cheap reinsurance, the aforementioned effects of the underwriting cycle on the reinsurance programs of AIG can be said to be particularly relevant. However, there are inherent risks in this process as can be envisaged from the history of reinsurance business in the UK market, for example, the case of the Insurance Corporation of Ireland, who did not receive any payback in the long run from their particular insurer clients in the UK. Therefore, the risk of an unfair play in business cannot be entirely neglected in this situation and the reinsurer may not envisage it as a feasible option to entertain the risk.
The cost of reinsurance in the market is another factor that is affected as a result of the underwriting cycle. While reinsurance is a trump card for the prevailing business of AIG which would have otherwise continued to suffer incumbent losses, the business ceded must evaluate that the reinsurance premiums need to be paid back to NICO in case of AIG, to exceed recoveries in the long run of payback in the achievement of short-term unit profitability by the insurer against the borrowed funds.
As such, consideration needs to be implemented before purchasing any reinsurance as it inherently means that the insurer will incur certain percentage of loss in profitability in the long run of paying back to the reinsurer.
Recommendations to optimize the reinsurance program with the underwriting cycle
Based on the analysis of the reinsurance programs of AIG UK, the current position of the underwriting cycle and the market situation in the UK and the impact of the underwriting cycle on the reinsurance program of AIG and the subsequent effects in retention and unit profitability, the following recommendations can be made.
Given the market situations prevailing and the analysis of the effects of the underwriting cycle to the reinsurance program which incurs some extent of profitability drop in the long run, it is recommended that unnecessary purchase of reinsurance must be prevented.
Based on the strategy devised by the CEO of AIG Inc in order to generate the underwriting profitability, the underwriting is recommended to be enhanced with key considerations for the reduction of expenses. This recommendation is also relevant to the previous one aligning with the necessity to prevent the unnecessary purchase of reinsurance which proves to be unprofitable in the long run for AIG.
Envisaging of the London Market risks in the future especially during the time of anticipated penetration of the reinsurance threshold for AIG is important for optimizing the reinsurance program. It is recommended to adopt and utilize an internal capital management model as a measure of achieving critical insights into the market risks. The same can be incorporated into the underwriting in order to optimize the reinsurance policy and positively affect retention and unit profitability in the long run.