The loss leader that became a liability

Who would be a UK liability underwriter? After years of losing money, you start to charge sensible prices, only to be accused of profiteering and endangering your clients' businesses.

The government has recently launched two inquiries into employers' liability (EL) insurance, one by the Department of Work and Pensions, the other by the Office of Fair Trading. Minister for Work Nick Brown told a recent ABI-TUC conference that he wanted EL insurers to be "profitable, but not socially exploitative".

While the government's desire to investigate allegations of cartel price-fixing is reasonable, the industry should stand firm in the face of such scrutiny.

Rising cost of cover cannot be attributed to anti-competitive practices. The remarkable thing is not how expensive EL has become, but how cheap and unprofitable it used to be. If anything, prices may have to rise further.

EL underwriters have been bleeding red ink for years. And it should be remembered that these loss ratios are likely to become even worse when the claims have finally developed and all latent trends have fully emerged.

The difference, post-9/11, is that insurers view EL from a strictly technical standpoint. Whereas EL used to be seen as part of a package - sometimes even a loss leader - insurers now regard it as a stand-alone class of business. They have analysed their data and, sometimes using simple financial models, they have tested old pricing assumptions.

Obsolete pricing
As a result, it has become clear that EL risks were historically under-priced in three critical areas: exposure, frequency of claim and severity of claim. Add in a more recent factor, the soaring cost of capital, and insurers face a "quadruple whammy" that renders the original pricing structures obsolete.

The increased exposure has been especially noticeable in the medium-to-large commercial risks, typically companies employing in excess of 500 people.

In the soft market, underwriters were willing to overlook increases in the insured's staffing levels, rather than lose a client.

Yet, if staff numbers rise by, say, 10% your exposure to an EL claim is likely to have increased. It goes up even further when, as is usually the case, the average annual worth of each member of staff increases.

Until recently, it was not unusual to find insurers accepting up to 50% or more extra risk in a relatively short space of time without any compensating increase in premium. The table above sets out these points with a fictitious case containing parameters that should be treated as illustrative only.

Claim frequency and severity are inter-related. Both have increased as a result of contingency fee arrangements, after-the-event expenses and the general increase in litigiousness. Even apparently benign strands of EL, such as clerical staff, have become dangerous.

Claimants are more aggressive and wide-ranging in the scope of their demands. They have been assisted by legal changes, often retrospective (such as lower discount rates and increased general damages), that have added to severity. Many claims, especially at the higher ends, have been seriously under-reserved. This is in no way attributable to loss adjusters. As an actuary, I know how difficult it is to reserve a portfolio of personal injury claims. Reserving for an individual claim is perhaps an even more complex process.

Insurers find they have covered risks the underwriters never intended, such as long-term illnesses that may (or may not) be caused by their employment. Asbestos and repetitive strain injury will not be the last types of claim to catch the industry unawares. Who knows what claims will emanate, for example, from call centres over the coming decade or two? What about employees who passively inhale the tobacco smoke of their colleagues? This uncertainty is one of the components that insurers must build into their prices if they are to trade at a profit given the long-tail nature of the business.

Inconsistency
Add in the imperative to include a profit margin in the premium - rather than relying on investments - and it will not be difficult to justify recent increases to government.

This will not, however, end the crisis. Nor will it help the businessman who finds that a compulsory class of insurance has risen in cost by at least 15%; still less to one forced to pay an extra 100% or even 200% or 300%. He or she might legitimately complain that the insurance industry has been inconsistent in its pricing. But, even at these levels, no one is making an indecent profit.

Any solution can only lie with government, and must include a review of the current EL system. Is it desirable or practical, for example, to insure against all workplace diseases - even those that may emerge many years down the road?

Moving on
The government might look at legal fees and associated administration costs, which account for over 30% of the EL premium base. These could be cut with the introduction of a no-fault or workers' compensation scheme, such as practised in the United States and many other countries. Although the profitability of US Workers Comp also leaves a lot to be desired, it is a cheaper way to deliver insurance.

Wherever the solution may lie, it will only be found when the debate moves away from having to justify the prices charged by insurance companies. Achieving that switch in agenda is a challenge for the whole industry.

Raj Ahuja is a partner at non-life actuary EMB