Large corporations have become so complex that many are dangerously underinsured for key business risks. It's a problem no one, either inside corporate leadership circles or in the insurance sector, knows how to fully solve. In some cases, corporate risk managers do not even realize the problem exists until a large loss occurs.

Businesses have become more and more complex for decades, as they have expanded globally, engaged in extensive merger and acquisition (M&A) activity, and built cross-border sales and supply chains. This complexity has been exacerbated in recent years by operational responses to the global financial crisis, technological innovations, the rollout of new regulations and corporate governance initiatives in many jurisdictions, and internal cost-cutting programs.

Corporate complexity is mirrored in the increasing complexity of insurance policy contracts and how those policies respond to different types of loss. Insurers are redefining the scope of their policies through new specifications on which causes of loss are insured, which costs of incident response are covered, which parties fall within definitions of “insured,” how the many exclusions and extensions work together, how overlap between different policies is resolved—and the list goes on.

The growing complexity and specificity in policy contracts have also led to the emergence of so-called coverage “black spots” in the commercial insurance sector. Corporate risk disclosures have failed to keep pace with the high rate of business change, and commercial insurance policies increasingly fail to reliably cover complex risks. As a result, many businesses face significant exposures because their insurance coverage is inadequate. And for the most part, the leadership teams at these companies are unaware of the risks they face where insurance no longer fits. They may not discover the gaps in their insurance until they suffer a big loss and their insurer rejects the claim.

Research Shows Significant Increases in Risk Complexity and Loss Volatility

An industrial-risk study carried out by Mactavish, in association with PwC, looked at the five-year period between 2009 and 2014. It uncovered a significant increase in risk complexity faced by many U.K. business sectors.

More alarming, many of these risks were not adequately disclosed to, or understood by, insurers. We found that variations in contractual terms are on the increase. We discovered companies in which operational streamlining has reduced business resiliency. And we uncovered situations in which compressed timelines for product development have increased launch risk and blurred the traditional boundaries between product and service offerings, opening companies up to new types of claims.

Our study predicted that insurers would struggle to keep up with the rate of business change because of systemic weaknesses in how insurance is placed—in particular, because cost-cutting has reduced insurers' technical risk analysis and resulted in overly standardized policies. We also predicted that this weakness in insurer processes would lead to an increase in the severity and volatility of both large losses and disputes between insurers and their customers.

Recent insurer results suggest these projections have come to pass. A Mactavish analysis of insurer balance sheets, reserve allocations, and annual results over the past few years shows a clear increase in the volatility of “man-made” losses for insurers—in other words, insurance losses with a cause other than weather events or natural disaster. The overall combined ratio of Allianz Global Corporate & Specialty (AGCS), for example, rose to 105.2 percent in 2017. This number is equivalent to an operating loss of 5 percent of premium income, and it's up approximately 4 percentage points year-on-year, despite a significant reduction in smaller attritional claims over the same period.

Such volatility in man-made losses is materially adding to losses stemming from natural catastrophes, which are also increasing, due in part to climate change. This creates a difficult situation for insurance companies, whose profitability has taken a big hit in both areas.

Black Spots of Insurer Understanding

To date, underwriting black spots have been most apparent in areas like construction professional indemnity (PI). In this market, a long period of attractive insurance pricing coincided with dramatically increasing complexity of risks. Smaller companies were getting involved in higher-profile projects; complex contracting and joint venture arrangements became commonplace; and regulatory developments impacted projects such as sports stadia or high-rise cladding. All these circumstances increased the complexity of PI risks in the construction industry, leading to poor underwriting results and sustained losses for insurers.

The situation came to a head late last year, prompting several underwriters to withdraw altogether from writing PI risk in the sector. Those insurers that stayed in the market are reluctant to underwrite risks on anything other than the most restricted terms.

We anticipate the emergence of further black spots in 2019 across the wider industrial landscape. For example, we believe that market conditions for directors and officers (D&O) liability coverage will rapidly worsen in the second half of this year. Underwriting D&O policies is notoriously complex, and practices have been put to the test by the “Me Too” movement and other scandals in recent years, with both claims frequency and average claim costs rising rapidly. At the same time, issues such as Brexit will open boards to a new range of potential allegations of mismanagement, as well as to new regulatory difficulties. If insurers don't fully anticipate these emerging D&O risks, subsequent losses will exacerbate the already-hardening market driven by several years of underwriting losses.

Cost increases and capacity reductions have started to hit companies operating in insurance black spots. This is only going to worsen in the coming year, and companies can expect to face sometimes-insidious changes that will reduce the value of their insurance cover. These changes might not always be as noticeable as reduced limits or increased deductibles. Instead, they will often come in by way of new geographic limitations; new exclusions for certain types of work in PI or for categories of D&O claims such as derivative claims against individuals; or even hidden within tweaked policy definitions.

In some cases, the consequences for the price and availability of specific types of coverage in certain areas may be extreme—for example, some construction PI cases in recent months have seen premiums more than triple, and simultaneous reductions in coverage mean the underlying rate actually being paid by the client has increased by more than six times.

Corporate Treasury, Finance, and Risk Management in the Crosshairs

Much of the onus for protecting a company against these types of risks has been placed on the shoulders of corporate treasurers, finance managers, and the risk function—in other words, personnel who do not specialize in insurance or legal matters.

The challenge is that advisers such as insurance brokers may not be any better equipped to understand the risks to their increasingly complex corporate customers, so they may not be able to recommend the appropriate insurance coverage, either. Nor is insurance placement typically a focus for internal or external auditors. Together, these factors create a dangerous hole in many organizations' governance practices.

As businesses continue to become more complex, and as this risk complexity filters through to insurers in the form of changes to claims profiles, companies need more than ever before to address the tightening of insurance supply.

Whoever in the organization is responsible for corporate risk management—whether treasury, finance, or a separate risk management function—must ensure on placement that the coverage they are purchasing matches with the company's risk and executives' expectations, in order to avoid being the victim of both a rejected claim and a subsequent knee-jerk restriction of cover.

Unfortunately, many companies are unable to effectively estimate their risks or to measure the degree to which their insurance policies—being limited to increasingly standard off-the-shelf policies—actually cover those risks. This problem is borne out by decades of Mactavish research demonstrating rising levels of litigation and disputes between all parties in the insurance chain: Our research shows that nearly half of all large insurance claims today are disputed by insurers.

It is plain to see that many corporations are unwittingly underinsured—or mis-insured—for the risks they face.

What to Do About It

In this climate, it's critical for the corporate treasury, finance, and risk management functions to better understand their risks and review the adequacy of their insurance cover. They also need to understand how to communicate their risk favorably, to meet all their legal obligations and to clarify the terms of their insurance coverage before it is too late. This communication should include: first, a major focus on identifying and documenting unusual aspects of the business model that may lead to a non-standard risk profile and, second, properly stress-testing policy detail against the known major loss scenarios.

Taking these steps will be important, even necessary, as developing losses begin outstripping the financial reserves insurers have allocated to pay for them. Coverage availability will become tighter in many markets over the next year or two. Limitations in coverage will lead to wild, punitive shifts in pricing and available limits—particularly in black spot sectors and for companies for which risk information is poor, irrespective of how well the business is actually managed.

Companies need to act now to mitigate the risk that their insurance firms will fail to respond when they're most needed.

Bruce Hepburn is the CEO of Mactavish, the U.K.'s leading independent expert on insurance placement and disputes, which has been operating in the commercial insurance sector for more than 15 years. Mactavish has been closely involved with the project to reform commercial insurance law in the U.K., an eight-year program that culminated in the Insurance Act of 2015.

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Avoiding Insurance Black Spots

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