The collapse of Independent Insurance took everyone by surprise. True, there were rumours of under-reserving, but the reality is that no-one – not the regulator, not the actuaries, not the city analysts, not the ratings agencies, not the financial press – saw the fall coming.
We need to understand how it could be that, as late as March this year, analysts were advising people to buy Independent shares, and ratings agencies were assessing Independent's financial strength as good.
Stuart Shipperlee, managing director of European operations at AM Best, said at the Insurance Times briefing for brokers on June 21 that his firm had not foreseen the collapse. Standard & Poor's were also rating Independent as financially sound until late in the day.
And yet, for months beforehand, Independent was in deep trouble, writing business at unrealistically low premiums, under-reserving for claims, and, it now seems, failing to record claims and blocking their internal auditor.
There is the familiar pattern – a dominant chief executive, projecting a superbly confident image, and implying that other companies weren't bright enough to keep up. And everyone, more or less, bought the message.
Record profits dazzled analysts, who made Indie a stockmarket darling. The share price rose, seemingly justifying the analysts and increasing the capital value of the company. But it was all built on sand. Here's how it happened.
Profits for insurance companies are an art, not a science. Unlike an ice-cream company (which makes ice-cream, sells it and tots up whether the money from sales exceeds the cost of making and marketing the ice-cream), insurance companies are different. The money they get from selling premiums is invested. The investment income is known, the premium income is known and the costs of administration are known. What's left – what's unknown – is the amount that will need to be paid out in claims. Annual business is fairly straightforward. However, much of insurance has a long-tail with liabilities crystallising years after the premiums have been paid. The reported profits for an insurance company are, essentially, based on that company's opinion of the extent of their future liabilities. Insurance company profits, to an unusual degree, are opinion, not fact.
That leaves a lot of freedom for an insurance company to state the level of profits it chooses. Independent Insurance stated profits that were higher than other companies would have stated on the same business. This made Independent look good. But the profits were increasingly like the emperor's new clothes – they didn't exist. So how could the regulator have failed to spot what was going on and prevent it from getting out of hand?
The whole purpose of regulation is to protect the public by ensuring that companies act properly. In their own words, the main responsibility of the Financial Services Authority (FSA) “is directed towards monitoring solvency and sound and prudent management”. Independent Insurance is insolvent; its management was unsound, its management was imprudent. Here, if anywhere, was a case for the FSA to intervene. So why did regulation fail so completely? Turning again to the FSA's own words, “it is the responsibility of the management to run the affairs of the company and make sure that the solvency requirements are met”. Of course it is. But if the directors are not living up to their responsibilities, the regulators should know about it and should step in. Saying, in effect, that regulators expect directors to behave properly means admitting that regulation is not happening.
The warning signs at Independent were clear, and were missed by almost everyone:
Add to all of this an aggressive growth strategy (nothing wrong with that in itself) and you have the prospect of a company racing to stay afloat, hoping that ever-rising premiums will keep it one step ahead of ever-rising claims. That is surely why Independent – after exhausting growth in annual policies – had to go for growth through longer-term policies, with longer-term and less quantifiable risks. In this scenario, everything looks rosy until the train goes off the rails.
This seems to be precisely what happened with Independent. The directors were not in charge of the company; the regulators were not in charge of the directors; the actuaries (until very late in the day) were not sending out warning signals; the auditors did not say that anything was amiss; City analysts continued to recommend the company; the ratings agencies continued to say it was strong. There was a total failure to protect brokers, policyholders, trade creditors and all those affected by the policyholders' lack of cover.
Conflicts of interest
There is also the issue of apparent conflicts of interest for Independent's professional advisors. Auditors KPMG were paid nearly £600,000 for their audit, and nearly £900,000 for other consultancy services. There is no suggestion that payments for consultancy services made their audit other than professional, but it is uncomfortable for an auditor to take large amounts of non-audit business from a company which it is auditing. Actuaries Watson Wyatt were insured by Independent. Although there is no suggestion that their advice was other than professional, it was obviously in Watson Wyatt's interest that Independent should continue trading.
Either we learn from experience or we don't. Insurance Times believes that the lessons must be learned from Independent so that, in the time-worn phrase, nothing like this happens again.