Insurers are headed toward a crisis after underpricing casualty risk for a decade.
- By Stephen Catlin
- February 2020
The insurance industry is facing a crisis of catastrophic proportions. Unfortunately, most people have not yet realized it or—perhaps worse—have simply chosen to ignore it.
This crisis, in my opinion, is being created by a vast shortfall in loss reserves for casualty business, particularly U.S. risks, underwritten over the past 10 years. I mentioned this problem in my last column for Best's Review, but I believe it is so important that I would like to explore it further.
The situation is quite simple. Insurers have significantly underpriced casualty business for the past 10 years. How could this happen? Because of the lengthy tail inherent in casualty claims, if an insurer's pricing for casualty business has been wrong in one year, it's probably been wrong for five to 10 years if rates have not risen significantly. That's where I believe we are today.
If one looks at casualty underwriting over the past 10 years, the rates quoted in 2019 were on average about half of those charged 10 years earlier. At the time the business was underwritten 10 years ago, it was probably booked at a 99% combined ratio; now this business is likely developing in a range of 105% to 125%.
If one then examines the risk exposure over that 10-year period, I estimate that the actual casualty exposure has increased by 50% or more, due both to general inflation and, more notably, the “social inflation” that impacts personal injury awards and settlements, particularly in the United States. For example, Swiss Re reports that the median cost of the 50 largest U.S. bodily injury claims nearly doubled from $28 million in 2014 to $54 million in 2018.
When all of this is combined, I estimate that most insurers have been writing casualty business at effectively one-third of the risk-adjusted rate they charged a decade earlier.
Looking back over the 10-year period, I believe that the industry's casualty reserves could be deficient to the tune of $100 billion and perhaps as much as $200 billion. That's the equivalent of three or four significant natural catastrophes in terms of cost. Even if the shortfall were to be addressed gradually over five years, the industry would have to come up with an additional $20 billion annually, assuming the deficiency is at the low end of my estimate.
The casualty reserve deficit will most likely be replenished over time. However, it is not impossible that insurers could be forced to address the shortfall all at once, especially if a contributing factor, such as a truly major natural catastrophe or severe global financial dislocation, causes undue strain on insurers' balance sheets.
It could prove to be an interesting time for external auditors and actuarial consultants.
Of course, deficient casualty reserves are nothing new. The industry experienced unprecedented upheaval in the mid-1980s due partly to a huge gap in casualty reserves. Rates skyrocketed, capacity shrank and several large U.S. insurers were later declared insolvent due to deficient reserves.
However, most people under the age of 55 who are now working in the insurance industry likely do not remember this crisis. That may work to our advantage. The industry could benefit from some fresh thinking.
This is another reason why insurers must recruit intelligent young people who by nature will think differently than the industry's current leadership. The new generation of professionals now entering the industry have grown up in a digital society with unfettered access to huge amounts of information in real time. Those in their 20s and 30s know how to use data much better than my generation.
Doing a better job of recruiting and nurturing bright young talent—who can see the intellectual challenges inherent in the insurance industry and who can use technology to actually learn from the past rather than continue to make the same old mistakes—is our best way forward.
Best’s Review contributor Stephen Catlin is the founder of Convex Group and Catlin Group and former executive deputy chairman of XL Catlin. He is a member of the International Insurance Society’s Insurance Hall of Fame. He can be reached at firstname.lastname@example.org.