Seeing the error in their ways

Martin King, Class Underwriter — International Professional Indemnity — AEGIS London.

What went wrong in Lloyd’s international E&O market? AEGIS London’s Martin King knows. He’s seen it all before.

As a practitioner with 37 years’ E&O experience – 31 of those as an E&O underwriter – the current hard market in International Errors and Omissions (E&O) business is my fourth. This makes me relatively rare in London’s E&O space. Why? Because many E&O underwriters find their careers implode in their late 30s or early 40s.

It takes, on average, 15 years to ‘make’ a liability underwriter, so anyone under 40 is unlikely to have experienced a hard market and, therefore, have the experience to handle it. Many underwriters are not granted the flexibility to take advantage of changes in market conditions. Therein lies much of the reason for the problems currently besetting Lloyd’s international E&O market.

Today, international E&O is in a state of turnaround. It’s gone from being one of the market’s naughty children to what could be described as on the road to respectability. But that road has some distance to cover yet.

Damaged reputation?

Why has E&O found itself the focus of Lloyd’s displeasure? True, E&O has never had the best of reputations in London – it’s always been prone to feast or famine. Historically, E&O claims have had periods in which they have been overly disproportionate to income generated. It is a class prone to recessionary claims, sometimes subject to social inflation, whereby a change in public opinion leads the courts to be highly sympathetic to a plaintiff.

Certainly, the E&O market has seen periods of profitability. The 9/11 attacks in 2001 rescued the market from a combined ratio of around 140% and ushered in price rises of over 40%. By 2003, it was up by another 25%. With reinsurers pushing on their side, these were the halcyon days for E&O underwriters in London. But as rates plateaued in 2004 and began to turn south, a new, far less benign era dawned. The global financial crisis of 2008 still did not stop new capacity piling into what appeared to be a profitable class. The reality, though, is that we’ve had compound rate reductions for 15 years, to a level at which bargain basement rates charged by some insurers probably need to rise by at least 50%.

Past performance, as we all know, is no guide to future performance. Yes, everything looked rosy in the E&O rear-view mirror, but up ahead the underwriting environment was reconfiguring itself. This is ultimately what led so many syndicates to place E&O in their decile 10s in response to Lloyd’s call for action. Since Lloyd’s made it clear that such poor returns were no longer acceptable, seven E&O capacity providers have pulled out with remaining insurers adopting a more defensive position.

Over-capacity and wrong assumptions

In addition to poor underwriting discipline, hedge funds faced with low returns in traditional markets poured some of their capital into Lloyd’s, where returns of 10% seemed feasible. True, this was clean capital, but its effect was to depress prices further.

Another problem that new arrivals faced was that, in E&O, it’s easy to assume that a policy written on a claims-made basis is short-tail, which in turn makes it easy to fall into the trap of under-reserving. This means that, in the short-to-medium term, the portfolio can look quite profitable, but when actuarial assumptions used for claims development are proved inadequate, profit must be returned to reserves, and the profit-and-loss account on a GAAP basis can suddenly be in a loss position.

This can be particularly difficult for insurers who are quoted on the Stock Exchange, as any profit earned is legally obliged to be declared on ‘day one’. If you consider that incurred claims on a long-tail account usually develop over a seven-year period, it is very difficult to accurately estimate the value of future claims after only 12 months.

The slow-turning supertanker is an over-used metaphor for the speed at which the market changes course but in this case it’s apt. A year-and-a-half onwards and Lloyd’s heightened oversight combined with restrictions on the supply of premium income are having the desired effect. Rates are rising – although this means the limits on premium income are being reached more rapidly, so some E&O underwriters are beginning to run out of income. This means that as the year progresses, rates will rise further as the supply of underwriting capacity diminishes, with the last quarter of 2019 proving particularly difficult for brokers.

Of course, the big question for the market’s surviving E&O underwriters is how long the current hard market will last. What makes that difficult to answer is that this hard market is different. In the past, the rising cost of treaty reinsurance has pulled the pin from the grenade. But this time, Lloyd’s itself has driven the change, and for this reason, the current hard market is likely to remain in place for longer than during previous cycles.

Hardening prices

Estimates suggest that the current E&O market environment could last until 2021, which is good news for underwriters. However, there’s no point fitting a new set of tyres to the market and then driving it into a wall. It’s no good for clients when they pay X one year, then pay three times X the following year without a claim, as it makes it seem as if the underwriters don’t have control of their business.

Lloyd’s remains the gatekeeper for E&O, but it’s a fine balancing act. The market’s regulators must ensure that they don’t clamp down so hard as to extinguish innovation.

If a syndicate has a poor E&O track record, then it is better to reduce such a syndicate’s income while allowing more profitable syndicates to flourish. In the recent resubmission of Lloyd’s syndicates’ business plans, syndicates with good past performance have been permitted to grow, in order to be able to maximise opportunities presented as the E&O market hardens.

The E&O market has not yet returned to the halcyon days of 2003, but E&O underwriting is in ruder health than it has been for some years. Both Lloyd’s and underwriters have a duty to keep it in such a state.

First published in Insurance Day 28 Jun 2019.