Inept Management Kills More Reinsurers Than Catastrophes

"What causes underreserving?" he asked. "Its writing wrongly priced business, its failing to control terms and conditions. Its not recognizing claims development trends. Its inadequate investment returns."

"In short, management error," he suggested.

He said one of the risk factors for management error is diversification, because it requires complex management reporting systems and companies get involved in areas that they dont necessarily understand.

As an example, he recalled attending a presentation to equities analysts by a U.K. insurer that suddenly announced a surprising loss. It listed the various sources of this loss, including food riots in Liberia, he said. "I went up to the chief executive afterwards and said, Peter, I didnt know you had a business in Liberia. He said, Frankly old boy, until a week ago, neither did I."

Indicating that big isnt necessarily better in the reinsurance industry, Mr. Hitchings pointed to Swiss Re statistics showing that in the years from 1990 to 1995, larger insurers were less profitable than smaller insurers.

"Size requires long chains of command," he said. "Wealth creates a preference for growth over profit."

He called the wealth effect a "reversion to mean."

"Rich companies can afford to lose money, so sooner or later they surely will," he added. "Small companies cant afford to lose money, so theyre more careful."

Mr. Hitchings noted that the sources of the change in net assets of the European insurance industry during 2000-2002 were the World Trade Center losses, adverse loss development and the fall in value of investments. He said that 80 percent of the drop in net assets was due to the fall in the value of investments.

Indeed, he said, Munich Re is currently suffering in part from its "absurd" gamble in bancassurance and overexposure to equities.

Mr. Hitchings said he thought the assessment of equity risk was a major flaw in rating agencies analysis of companies.

There ought to be a way of looking at equity risk that punishes Munich Re for "its ludicrous overexposure to equities in 2000," but doesnt punish it for not panicking and selling its equity holdings at the bottom of the market.

Mr. Hitchings dissuaded his audience from the popular view that the reinsurance industrys capital base has fallen by 40 percentmuch more than the new capital thats been raised.

The main source of the reduction in capital in the reinsurance industry since Sept. 11, he said, has been Munich Re itself, whose capital has been reduced by 67 percent, mainly as a result of its equity investments.

(Munich Re recently announced it is raising nearly 4 billion euros in capital, or $4.7 billion, through a rights offering.)

He noted that Munich Re hasnt been acting like a company that has lost 67 percent of its capital over the last two years, because it hasnt been cutting its premium writings by 67 percent.

In a discussion about the difference between the requirements of rating agencies and investment analysts, Mr. Hitchings said there are inherent conflicts between the two sides because the rating agency represents the customer, while the investment analyst represents the investor.

"The customer traditionally likes as much capital as possible from the insurer. The investor would like the insurer to have as little capital as it can prudently get away with," he said.

As a result, as an equities analyst, he thought the optimal rating at which a company can maximize its return on equity is probably in the "single-A" range.

Mr. Hitchings recalled another experience with a U.K. composite company many years ago, which was going through a slight capital crisis. "The executive gave a very eloquent presentation about the efficiency of running an insurance company on a modest solvency margin. Through very, very complicated graphs, he showed that the ideal optimal solvency margin for an insurance company was in fact 42 percent, which was pretty much exactly what they had at the time." (Solvency margin is shareholders funds divided by net written premiums–a figure that indicates the financial strength of the company.)

He also spoke of another British composite, which many years ago gave leather wallets at Christmas to the equities analysts. One of the executives joked to the analysts that it was a "very, very special wallet, a magic wallet: however much money is in it, its always enough."

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.