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Dark arts demystified

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Buyers of insurance should support any effort to make the business of risk transfer transparent.

This is because it enables them to make more economically rational decisions and makes it more difficult for others to pull the wool over their eyes. Whether it be commission payments to brokers, the construction of financial reinsurance contracts or simply the presentation of loss statistics to work out a profile, transparency enables all parties to find and stick to the truth and reach sensible conclusions.

This is why insurance buyers, theoretically, ought to support the efforts of the London-based International Accounting Standards Board in its effort to demystify the weird and wonderful world of insurance accounting.

Many people in this business would argue that it does not really matter how insurance companies account for the business, so long as the credit rating agencies—and to a lesser extent their brokers—have a vague idea of how to read the numbers that enables them to spot the good ones and bad ones.

This is not a bad argument. Insurance buyers are not, on the whole, trained financial analysts who specialize in the dark arts of analyzing insurance company reserves and do not want to be.

Most risk managers in Europe have lots more things to do like work out their own risk profiles, appetites and strategies to cope with their specific risk horizons.

The selection of risk partners is on the whole left up to the aforementioned expert advisers.

But, it must also be said that any insurance buyer who is half serious about their job ought to take at least a passing interest in this debate. Insurance companies can quite suddenly and unexpectedly go bust fooling even the most intelligent and highly paid analysts right up to the last moment.

Independent Insurance Co. Ltd. in the United Kingdom, Reliance Insurance Co. in the United States and Gerling Globale in Germany are all very high profile recent examples of companies that went down and left considerable quantities of egg on the experts' faces.

One suspects that those insurance buyers who found themselves trying to answer awkward questions in the boardroom about why they placed such a large portion of their coverage with the above named failed companies will have faced nothing but sneers had they simply tried to shift the blame onto the analysts and brokers.

It also makes sense for risk managers in Europe to become involved in this debate because it is intrinsically linked to Solvency II, Europe's proposed new capital adequacy regime for insurers.

The International Accounting Standards Board will not let anyone divert it from its mission to make the valuation of all assets and liabilities in the world on a fair value basis—even if the liabilities may have lives of 25 years or more.

The European Commission has therefore sensibly decided that Solvency II will be based on fair value so that it dovetails with the accounting standard when it finally arrives in 2010 or beyond.

Together, these two new rulebooks could quite radically alter the way capital is measured, managed and—critically for buyers—allocated by line, territory and form, within the global risk transfer chain.

Those insurance buyers who do not take an interest could therefore be in for some nasty shocks in a couple of years' time that could well lead to some uncomfortable conversations with the chief financial officer.

Beating the cycle

It was interesting to hear a range of leading U.S. and Bermudian insurers explain to BIE during the Risk & Insurance Management Society Inc.'s recent conference in New Orleans how they are going to maintain top line growth without wrecking the bottom line.

The party line was remarkably consistent. Everyone says that they have the specialist knowledge, products and distribution networks required to ensure that they can beat the cycle.

All these companies have the discipline, focus and risk management skills required to maintain a decent level of profitability and even volume growth as the market begins to soften after peaking last year, they say.

There is absolutely no chance of a return to the frenzied days of the 1997-2002 underwriting years because insurance and reinsurance companies have learnt their lesson.

They have learnt how to manage their capital much more sensibly—generally handing it back to investors rather than making unwise acquisitions—and the credit and equity analysts are much more realistic than they used to be.

Indeed rather than rewarding chief executives for insanely ambitious growth targets during softening phases of the cycle, credit and equity analysts are now jumping on executives from a great height if they get too carried away with the capital, it is pointed out.

But, and it's a big but, while this all makes sense, the fact is that capacity for primary European business continues to rise and overall rates can only continue to fall.

It may not be the bloodbath of 1997-2002 all over again but buyers can expect cheaper coverage this year than last despite what companies say, and it will be more difficult for the insurers to make a decent return as time passes.

Perhaps the biggest constraint on insurers will come from the reinsurers that, up to now at least, appear to have been remarkably careful with their capital.

There are, as ever, rumors of companies offering ridiculous prices but little evidence so far to back this up.

If anything, the proposed takeover of Switzerland's Converium Holding Ltd. by Paris-based SCOR S.A. can only help to maintain what Brian O' Hara, president and chief executive of Hamilton, Bermuda-based X.L Capital Ltd. neatly described as "Terra Incognito."