The sudden downfall of Independent Insurance is bound to leave a mark in the industry's history books and an extremely bitter aftertaste. The great mystery, though, is how the struggles of such a key player in the insurance market, which last year had assets of £1.4bn, could escape undetected for so long.

Stuart Shipperlee is the managing director of European operations at rating agency A.M. Best. He believes that, six months ago, the insurance giant did not look like it was going to go into provisional liquidation.

“It apparently had good capitalisation, a good historic operating performance, subject to reserves being adequate, and price increases in main lines suggested results should have been better still going forward,” he says. “There was also a strong market position, although there were some question marks about reserves being lower than its peers.”

Reserves not enough
Independent was consequently given a strong financial strength and high stock market ratings. In April, the group had assets of £1,718m, gross loss reserves worth £472m, other liabilities of £912m and shareholders funds totalling £334m.

Today we know that those reserves were inadequate for its long-tail liability business. This means the company's apparent financial strength which was represented in its year 2000 audited accounts was grossly overstated.

“The major insurance rating agencies have sophisticated techniques for examining the risk that claims on current business are greater than premiums received and investment income earned and in identifying the risk that value of assets fall, such as equities, bonds and recoveries from reinsurers,” explains Shipperlee. “But evaluating reserve adequacy in the UK is dependent on the quality of information received from the company.

“As a result, since the reserve adequacy appeared satisfactory to the internal and external actuaries, the company had historically looked reasonably capitalised.”

In February, warning bells began to ring. First of all, Independent announced a profits warning and a need to increase reserves largely due to claims inflation and partly to cover losses in its French operation.

“We didn't foresee insolvency coming but put Independent's rating under review on February 14,” says Shipperlee. “We envisaged a need for extra capital given the growth and increased concerns about reserve adequacy but the company was adamant it would be able to raise fresh equity, given UK market opportunities.

“Although uncertainty was growing, the external actuaries continued to believe reserves were reasonable and Independent purchased a large amount of reinsurance to provide ‘comfort' on reserves.”

The following months saw mounting concern about the timing and scale of capital raising but Shipperlee says this only remained “a relative concern, since reserve adequacy was still believed to be reasonable and the company was less strong but not seemingly in real trouble”.

On April 20, A.M. Best then decided to downgrade Independent to A- (excellent) and kept it under review because of “lack of progress and the well-publicised reserving problems” it was experiencing.

Dropping in the ratings
By June 13, the capital had still not been raised and the rating was then changed again to B++ (good) and still under review, even though the company maintained the capital raising was well advanced and it had no expectation of further reserving problems.

The following day saw Independent's hopes plummet further. To begin with, its management is believed to have told bankers HSBC and Collins Stewart that the external actuaries had changed their view and now had real doubts about the reserve adequacy.

“We now know that doubts also emerged about the true nature and cost of reinsurance contracts protecting reserves, increasing concerns over the company's financial position,” says Shipperlee. “The combined effect was that the bankers abandoned equity raising – an action that meant, once announced, the financial position of the company was now in real doubt.”

On June 14, Independent declared that it could not raise the extra capital and that it was to temporarily close to new business. A.M. Best downgraded the rating to B- (fair), in the “vulnerable” range of its rating scale.

Then rumours of further trouble began to circulate, saying that claims had not been properly entered into accounts and that the finance director and deputy managing director may had not been fully informed about the reinsurance contracts.

Why the discrepancies?
But what could have possibly caused such a mismatch between Independent's reported results and a far worse reality? Shipperlee believes there are a number of possible reasons for the discrepancies.

“There were factors beyond the company's control such as liability claims inflation of no-win no-fee cases,” he reasons. “But the company could have managed its claim reporting systems and underwriting.

“If the internal systems of an insurer don't fully and accurately capture claims information, then both current losses and reserves required for the future will be understated.”

The impact of the collapse of Independent is still unfolding and accountants from Price-waterhouseCoopers have indicated it could take up to a year to establish a fully functional scheme for creditors.

“What we can learn from it won't be clear until we have more details on what exactly happened,” says Shipperlee. “But the likely lessons are that companies reporting very substantially better results than their peers in long-tail liability business may need to be assumed to be too optimistic.”

This would mean that analysts would have to assume a firm's reports are made through rose-tinted glasses, regardless of the company management's rationale about why its underwriting quality supports this performance.

“So much of this story is about reserving accuracy,” adds Shipperlee. “Actuarial reviews of long-tail reserves have always had significant uncertainty, no matter how thorough.

“But this uncertainty has grown with the trend towards no win, no fee litigation, and extra capital may now be needed to cover this increased uncertainty.”

The problem insurers face is that for every pound they set aside for reserves to fund potential future claims, a pound will be deducted from their final profits for that year.

“Finally, the need for rigorous corporate governance is almost an inevitable conclusion, especially for strong, clearly independent and insurance-savvy non-executives,” says Shipperlee. “This is especially important as insurance results are opinions, not facts.”