Posted on 17 Dec 2009
Swiss Re's new sigma study, "Commercial Liability: A Challenge for Businesses and Their Insurers", highlights the challenges of managing and insuring liability risk. The authors note that the best products and the best underwriting methodology for liability risk are no substitutes for adequate pricing. Prices should reflect escalating claims trends and the uncertainties of a rapidly changing technological and legal environment.
Third party liability is among the most important risks that businesses face. Liability insurance protects against “the legal obligation to compensate third parties for losses or damages for which they are liable.” This includes very different risks: companies seek protection against claims resulting from product defects or improper use of certain products by the consumer. Medical doctors and hospitals insure themselves against medical malpractice. Boards of directors, supervisory boards or management may also seek cover against claims relating to violations of the duty to exercise care. This type of cover has increased in importance since the onset of the current financial crisis.
Liability insurance is growing in importance around the world…
In 2008, businesses spent approximately USD 142 billion on liability insurance worldwide. Premiums in the US, the largest market by far, were USD77 billion, more than half of global commercial liability premiums. The UK, the world’s second largest market, generated commercial liability premiums of USD 12 billion in 2008. Commercial liability premiums in Japan and Australia, the largest markets in the Asia-Pacific, were USD 5 billion and USD 4 billion respectively. In most emerging markets, penetration of commercial liability insurance is low, but growing at double-digit rates.
…yet running it as a profitable business is a challenge for insurers
“After a few profitable years, there is a risk that insurers again under-price the business.” said Thomas Holzheu, one of the authors of the study. Because liability insurance is a long ‘tail’ business – ie claims tend to occur over a longer period of time - insurers have to price in the rising claims trend and the huge risks involved in this business. Holzheu added: “Under-reserving, which usually goes along with underpricing, is very dangerous both for insurers’ long term profitability, but also for policyholders, since it undermines the sustainability of insurance protection.”
Holzheu noted: “Commercial liability rates are declining in all markets, especially in the US since 2004. Meanwhile, prices continue to fall in all liability lines of business. Because interest rates are low, business cannot be cross-subsidized with investment results; therefore, prices should instead be increasing.”
Why liability insurance is increasingly difficult to underwrite
The traumatic experience of the 1980s, when companies and their insurers in the US were made retroactively liable for claims relating to environmental damages and asbestos, is still in many insurers’ minds when they think of liability threat scenarios. Inflation is another area of concern, which is quickly attracting attention. A lesser known fact is that unexpected inflation in the US during the 1980s contributed significantly to the soaring losses the industry faced during the liability crisis.
Emerging risks due to technological and social developments are a constant challenge: new insights into and changing standards around food safety, environmental pollution, employment practices and the compensation of financial loss are, for example, risks that insurers closely monitor. Roman Lechner, co-author of the sigma study, said: “Fortunately, none of these emerging risks has evolved into the next asbestos — yet.” He added, “The problem is that emerging risks cannot be assessed with traditional actuarial methods. They can only be determined after claims have accumulated following precedence verdicts.“
Another growing concern is the rapidly changing culture of compensation. Damage awards are increasing, especially those related to pain and suffering. Also, various countries in the European Union have adopted collective redress mechanisms, ie class action mechanisms, which could lead to larger claims..
Companies, insurers and governments must take steps to keep liability risks insurable
The first line of defense for avoiding liability costs is risk prevention. Companies and their risk managers need to assess and mitigate the risk in their businesses. Insurers must systematically monitor the drivers of liability claims and build them into their actuarial models. The underwriting process must at all times remain focused on maintaining control over exposures and underlying profitability. Governments should guarantee a predictable framework by refraining from frequent changes to liability rules, eliminating procedures that contribute to unpredictable outcomes or delays in claims resolution, and avoiding retroactive liability. There is also a need to keep levels of liability compensation within reasonable limits.