Key challenges for the insurance and reinsurance sector in a difficult economic climate

Good afternoon and thank you for those kind words of welcome.

This afternoon I would like to give a market perspective of the future for the insurance and reinsurance industry.

I come prepared with no fancy diagrams and no complex theories. But I would like to share my thoughts as the Chairman of Lloyd’s, perhaps the world’s oldest and best known insurance market, on two key issues.

First, what will be the impact of the economic crisis on the insurance and reinsurance markets? I will answer this question using information from Lloyd’s, from Europe, and from around the world.

Second, how is the wider risk environment changing as recession takes hold? Here, I will outline the three key risk challenges which we need to respond to – climate change, terrorism and political instability, and corporate liability.

I will start, then, with the outlook for the insurance industry.

First of all, we need to view the insurance industry in its wider economic context.

I would like to share two quotes from around two years ago.

Quote number one. “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.”

Any idea who that was? It was the (then) Chairman of the Federal Reserve Bank Alan Greenspan speaking in early 2005¹.

Here’s quote number two. "Britain is today experiencing the longest period of sustained economic growth since records began in the year 1701."²

Any guesses? Yes, that was our UK Prime Minister, then Chancellor, Gordon Brown around the same time.

How dramatically things have changed since then on both sides of the Atlantic – and across Europe. History has since cast a very different light on those two particular statements. But of course, the last two years have – perhaps understandably – caught even the most knowledgeable experts by surprise.

What does 2009 hold? I don’t think anyone knows the answer to that, but we can assume that there will be more bad news before things get better. The governments in both the UK and Germany have confirmed that we are in the deepest recession for 70 years.

As a result of all the turmoil, we are in an environment where the financial services sector is under challenge, as never before. Redundancies, cutbacks, insolvencies – this is hardly our golden age.

The main priority over the next few years will be for the industry to ‘get back to basics’. The industry exists to keep wider society and the economy moving. Its purpose is not to create complex financial products which few people understand and from which very few benefit.

This process of rebalancing that has now begun, must and will therefore continue. There is a clear consensus for change.

Another key priority for financial services is to get regulation right. Regulation certainly needs to be more effective. We need to have more oversight over what we are doing. But I must sound a word of caution at this point: better regulation doesn’t mean knee-jerk reactions or equate to vast new rafts of legislation.

I make this point in particular because the regulation that is right for banks may not be right for insurers. An effective regulatory structure will therefore appropriately distinguish between different financial industry sectors.

What we also need – despite the temptation to succumb to protectionist thinking right now – is closer co-operation across borders, more harmonisation of standards and greater mutual recognition between different territories.

The EU currently has a strong opportunity to demonstrate real leadership to the rest of the world as we debate important regulatory questions and these are two points which must not be lost.

At this point I also want to examine the financial position of the insurance industry.

The dramatic bail-out of AIG America’s largest insurer proves that the insurance industry is not insulated from what’s happening elsewhere. Companies closer to home here in Europe have also decided to raise capital recently.

Insurance buyers will seek to cut costs during difficult times, and fraud may rise. New figures indicate that the recession is already prompting an increase in fraudulent insurance claims in the US[3].

Claims related to suspicious vehicle fires so far this year are already up 27%, and questionable claims related to slip-and-fall accidents are up 77% under commercial policies.

But despite some high profile casualties, the overall impact of recent events on the general insurance industry has been limited. The whole financial sector is not some house of cards destined to fall and the insurance industry is relatively well placed to weather recession.

First and foremost, insurance is an economic necessity, not a discretionary purchase. And although insurance is not immune from what’s going on elsewhere, this largely holds true, even as recession bites.

Homes, cars and businesses all need to be insured, irrespective of the state of the economy. A decline in construction and automobile manufacture will hurt growth prospects – but this will impact mainly at the margins because so much growth of insurance exposure is linked to renewal business.

Next, I will share some thoughts on Lloyd’s.

The Lloyd’s market has had to learn its own painful lessons about toxic liabilities in the past, lessens which stand us in good stead now. I refer to the transfer of 14 billion pounds of liabilities to Equitas in the 1990s.

Equitas is now a successful business which has since been bought by Berkshire Hathaway. But we have changed almost every aspect of the Lloyd’s business since then.

The creation of a new franchise structure in particular has led to fundamental changes in our business model – a model which has helped to keep us on course, despite record insurance losses in recent years.

In addition, Lloyd’s has always maintained a conservative investment strategy. We expect conservative strategies to remain the rule.

Meanwhile, the Lloyd’s market has retained a focus on traditional insurance and reinsurance products. Unlike some other insurers, Lloyd’s underwriters have stuck to what they are good at, and have not sought to diversify into complex financial products and markets – such as credit insurance – that they don’t understand.

This rejection of exotic products must have appeared highly unadventurous a few years ago, but now seems a prudent business model – especially when combined with our strong franchise performance framework.

This is borne out in our latest set of financial results.

Despite the financial crisis and the scale of natural catastrophes (and I will say more on that point later), we posted a market-wide profit of over €2bn  for 2008, a good performance - and frankly, better than we expected.

However, I must sound a word of caution at this point. The insurance market faces the challenge of its own market cycle right now. And there is no clear evidence yet of where the insurance cycle is going to end up this year – although we remain optimistic.

According to AonBenfield, some parts of the reinsurance industry, for example Gulf of Mexico windstorm cover, have already hardened, and the market hopes to see further hardening across other lines of business in the next 12 months.

But for too long the financial sector has operated within a bubble of unreality. By contrast, we need underwriting decisions built on economic reality. At Lloyd’s we are therefore entirely supportive when we hear our underwriters say that they will not underwrite unprofitable business or chase market share. Today this is the only prudent approach.

The insurance industry must, all the while, keep an eye on the emerging markets.

Lloyd’s success as an insurance market has always been based on our international outlook. The current state of the economy means that developing partnerships with emerging markets will now become even more important as scope for growth becomes more limited closer to home.

Just ten days ago I was in Brazil, where there was a very definite optimism about future growth prospects. Lloyd’s became the first overseas reinsurer to be admitted to the Brazilian market last year.

Meanwhile, on the other side of the world, our reinsurance business in China has been operating for two years. And closer to home, Lloyd’s has also recently obtained new establishment licences in Poland, Austria and Portugal.

For the second part of my talk today I would like to comment more widely on what the economic crisis may mean for the wider risk environment.

If we have learnt one thing from the financial crisis it is that poor risk management was a big part of the problem. But let me clear. Risk is not and should not be a dirty word. However, we need to work to understand risk. Only once we understand it, can we start to manage it, something which we know from over 320 years experience at Lloyd’s.

Today there are three particular risk issues which business and society perhaps need to work to understand better.

The first is liability risk.

One of our concerns is that a credit crunch, followed by a deep recession, creates the perfect breeding ground for a new increase in litigation activity.

There is typically a delay before claims tend to materialise from an economic downturn. Economic activity fell sharply in 1990 to 1991 while a raft of new claims arrived between 1992 and 1993⁴.

Boards now spend 13% of their time discussing litigation and most companies believe that stakeholders outside the US are now more willing to litigate generally.

Actions brought by employees and customers are the most frequent, but actions from shareholders, regulatory authorities and special interest groups are growing.

There are three particular concerns for Europe right now. One is that as globalisation takes hold, companies outside the US are growing more disposed to litigate generally.

Class actions could increase in the EU too because of shifting attitudes and new legislation.

Third, there is a perception that US courts are increasingly being asked to rule on cases that might have once been considered extraterritorial⁵. Indeed, the risk of being sued in jurisdictions with which the details of the claim have little apparent connection appears to be increasing.

Our view is that the economic outlook makes it more, not less, likely that society will see an increase in litigation and we must give greater attention to anticipating and forecasting emerging liability risks – not just those we know about.

Advancing technology, environmental issues and corporate governance are the three emerging areas of potential liability exposure about which CEOs expressed most concern in recent Lloyd’s research.

As I mentioned at the outset, another area of concern right now is climate change.

While 2008 will probably best be remembered for the credit crunch, it was also the third most costly year ever for insurers. We faced claims from hurricanes, floods, wildfires, earthquakes and cyclones.

These catastrophes claimed a quarter of a million lives around the globe, and cost the insurance industry €41bn. Lloyd’s alone will pay approximately €2.1bn in resulting claims, and the trend towards higher levels of catastrophe losses will only gather pace as climate change takes hold.

The economics of climate change are not yet entirely clear, but the indications are extremely worrying. We know that weather-related catastrophes are costing the insurance industry more than ever before.

There are some concerns right now that our focus on the economic crisis could all too easily become an excuse for inaction on climate change.

But despite the economic challenges we face, it would be an environmental and a business disaster to lose our strategic vision on climate change now.

Climate change will increase water scarcity, alter food production and dramatically change energy supply and migration patterns, as highlighted in a report we published last month.

The insurance industry has a key role to play in helping to change attitudes. We also need debate important issues like flood defence, how we can best adapt buildings and infrastructure, and development in high-risk zones. These are complex issues and we can’t just put them in the ‘too difficult’ box and walk away because we face recession.

And let’s get one thing straight. As well as significant challenges, climate change also presents us with real opportunities. Ultimately, society will adapt to the climate. It has no choice. And new technologies will be developed which will create huge opportunities for the economy – and indeed for insurers too.

Finally, I’d like to touch on terrorism and political risk.

Our work at Lloyd’s has highlighted the emergence of a new brand of home-grown terrorism. And the UK government agrees with us: home-grown terrorism is probably the greatest security threat we now face.

Another supposedly “new” risk is piracy. We are currently experiencing the biggest upsurge in piracy for four centuries. But, far from the story book images of old, today’s pirates are furnished with machine guns and rocket launchers.

In the west and emerging markets alike, rising unemployment and economic hardship mean that the number of vulnerable young people susceptible to extremist doctrines and criminality will only increase.

The key point I want to make is that international co-operation works. When concerted international government action took place to stem piracy in the Malacca Straits in Asia, the number of attacks fell dramatically – from 126 in 2003 to 26 in 2008. In the same way, incidents in Bangladesh have fallen from 47 in 2006 to only 10 last year⁶.

Of course, we cannot view what is happening offshore in isolation from what is taking place on land. Until there is a stable Somali government and a decent level of prosperity in the country the piracy problem off the coast of Africa cannot be eradicated.

However, above all, one thing is clear – insurers still have the appetite and the capacity to take on risk. Nearly all of the ships pirated this year are insured within Lloyd’s either by hull underwriters, hull war underwriters, kidnap and ransom underwriters or through reinsurance. Likewise, after 9/11, Lloyd’s was just about the only market to offer terrorism coverage, and we continue to do so today.

And in respect of terrorism, the private sector has a part to play too. In the UK, we are now coming to accept that the struggle with home-grown terrorism represents a struggle to engage with a lost generation.

Society will only conquer the threat if we start thinking and investing ‘long-term’, and business can make an important contribution to that process. A growing body of opinion now suggests that closer engagement by the private sector – both at home and abroad – can make a lot of sense for both the business and the local community.

As we reach the midpoint of 2009, more than ever we need to expect the unexpected.

We don’t yet know what global economics might have in store for us before this downturn is over, and we can’t be sure how the markets will look next Monday let alone next year.

But I would like to end on a positive note because the insurance industry is in good shape, despite the shadow of recession, and Lloyd’s remains stable and secure.

For our part, we will continue to work closely with clients, brokers and insurers here in Germany and around the world to help society respond to a challenging risk environment.

Thank you for listening. I look forward very much to your comments and to your questions on these and any other areas you wish to discuss.

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