PRESS RELEASE 6th January 2010
The below release contains separate sections below the main release with specific details for each of the INSURANCE, MANUFACTURING, CONSTRUCTION, RETAIL AND FINANCIAL SERVICES sectors. Please review as appropriate.
INSURANCE CRISIS COULD ADD FINAL CHAPTER TO CREDIT CRUNCH, WARNS MACTAVISH
Companies running increased risks in the wake of the financial crisis, and failures by company management and the insurance industry to address them effectively could create a ‘perfect storm’ in the commercial insurance market. This will prompt a new phase of the financial crisis, according to extensive new research by Mactavish, the specialist research firm that works with leading insurers, brokers and banks.
The first round of its Sector Risk Research Programme, published today, has involved in-depth consultations with senior executives at more than 250 major companies in the UK in the manufacturing, construction, retail and financial services sectors, mainly with turnovers between £50m and £5bn. 40 consultations with senior insurance executives were also held.
The research, which has been reviewed by the insurance practice at PwC and by analysts at Citi, shows that risks faced by companies have risen sharply due to the recession, increasing existing risks such as supply chain vulnerability, and adding new ones as firms adapt to survive. It also reveals that neither company management nor insurers have fully recognised changes to risk profiles, meaning insurance companies may be carrying unrecognised risks while firms’ cover may be inadequate, leaving investors exposed.
The report warns that: “Parallels can be drawn between large property & casualty insurance institutions today lacking the ability to fully understand changing risk exposures and more publicised past failures of financial institutions to understand risks assumed. While loss impacts naturally lag economic changes by several years, turmoil in commercial insurance is expected as a latter phase of the financial crisis.”
Key findings include:
- The effect of the economic downturn has been to drastically raise the pace of change in the business world, way beyond headlines on failure rates and bailouts. The speed, number and significance of important granular changes across most companies’ day to day operations are unprecedented.
- Such a severe recession has altered existing risks companies face and added new ones. Businesses are moving into less familiar activities, cutting costs and stretching themselves and their trading partners in order to cope with recession. For example, one high-tech manufacturer had doubled its rate of new-product launches in 2009 while cutting manufacturing lead times by 75% in a bid to cope with the downturn.
- Management focus remains on putting new measures in place, with few yet understanding or communicating how risk is different. For example, the research found that 65% of companies do not review how their risk is explained to insurers as part of the contract on which their company relies. This puts insurance cover at risk and may leave shareholders bearing unexpected losses at a time when capital is scarce.
- Insurance brokers and insurers have also so far failed to address these changes, suggesting systemic under-pricing of risk and a requirement for a potentially severe insurance market correction.
Bruce Hepburn, Chief Executive of Mactavish, said:
“Major business changes and great uncertainty around commercial risks have been caused by the recession, but nobody has really focused on this yet. This means that some companies are not properly insured, and insurers are carrying greater risks than they realise. Investors could end up bearing the cost of losses.
“The issue should not be underestimated. Companies are ultimately more reliant on insurance now given that few have the luxury of significant cash reserves and access to new debt remains limited.
“British firms contain new risks that have not been properly understood or reflected. As a result of this combining with existing pressures on insurers, the insurance sector and the companies it serves could be facing a perfect storm that would form another phase of the financial crisis. Our research suggests that company managements, insurers and investors all need to wake up to face this reality.”
Achim Bauer, partner, PricewaterhouseCoopers, commenting on the Mactavish research says, “Many commercial insurers have failed to keep pace with the unprecedented changes in commercial risk and the findings have revealed significant flaws in the way commercial risk is assessed and insurance placed”.
“Insurers need to act quickly to identify areas of their portfolio where underwriting is most seriously misaligned, adjust reserves and explain the implications to their stakeholder community. Failure to do so will only exacerbate losses and further undermine market confidence.”
Citi’s investor note on the research warns of the risk to the property & casualty insurance sector. It says, “a sharp increase in commercial claims could be the ’straw that broke the camel’s back’ – driving a substantial shake-out, but with real differentiation between the insurers who are prepared and those who are not.”
“It is likely that the impact of the recession has yet to work its way through the system, with the potential for the changed risk environment to have much greater impact in 2010 and 2011. As such, we think this is an area that investors need to be on top of, as these trends could have a material impact on stock prices over the next 18 months, not only at a sector level, but also in differentiating between (…) insurers”
INSURANCE INDUSTRY IMPLICATIONS
These findings clearly have potentially severe consequences for the insurance industry which underwrites the risks concerned. A significant focus of the study was therefore in testing insurer assessments of the changes observed, the level to which they are currently understood and their impact on insurer policy.
Key findings included:
- Faced with sudden changes, the historic risk assessment models used by insurers become increasingly unreliable. Given the increase in risk, widespread under-pricing is inevitable through 2010 as underlying risk increases while rates suffer continued downward pressure.
- An increased and more uncertain risk environment will impact claims costs, even if it can take years to become clear. It also raises the importance of existing weaknesses in the system used to explain and underwrite individual risks, leaving company shareholders and insurers exposed.
- This introduces a new risk to earnings for Property & Casualty (P&C) insurers. Mactavish expects real variance in how exposed insurers are to this segment, and how well they are able to respond to the challenge of building closer customer relationships to better understand risks.
- The insurance industry continues to fail to communicate its value to customers – with depressingly little buyer recognition of the value provided despite greater-than-ever dependence of companies on insurance capital.
- This suggests that conditions are set for the type of extreme and localised volatility for which insurers have been harshly criticised in the past. The industry already works on very tight margins following fierce competition, and supported by an unusually benign claims environment recently. Recessionary risk impacts may break this cycle.
Mr Hepburn said: “The sheer level of business risk impact suggested by this research will become a huge issue for the insurance industry at a time when margins continue to shrink. Long-standing weaknesses in the system of understanding risk are increasingly exposed and history suggests some will rise to this challenge a lot better than others.”
Mr Bauer, PricewaterhouseCoopers, added: “This is a wake-up call to the insurance industry. Both insurers and insurance intermediaries need to fundamentally rethink how risk is assessed, how companies are insured and how to keep pace with an increasingly complex, uncertain and fast changing risk landscape. Taking action now will reduce the immediate business impact and strengthen their market position”
INDEPENDENT MANUFACTURING
Research in this sector focused on independent UK manufacturing companies between £50m and £5bn in turnover across a wide range of product categories, as opposed to subsidiaries of foreign companies where many UK risks are managed by the parent.
Key findings included:
- A sharp surge in outsourcing and overseas joint venture activity with the recession acting as a catalyst, significantly increasing supply chain complexity. Half of all sector respondents said they had a current project of this kind. Few had begun to analyse risk implications.
- Supply chain vulnerability has increased. More than 80% of respondents said this issue had changed their risk profile. Supplier failures, enforced single sourcing, reduced stock levels, cutting of excess production capacity and other issues were all cited as reducing resilience.
- Increased product development and diversification into new areas. In response to falls in demand, many firms have targeted new market segments, launched new products and extended product provision into a wider service offering. New products and markets typically increase failure rates while service offerings create new insurance requirements. Few firms had considered insurance issues.
- Firms have faced pressure to accept extra liabilities in areas like product warranties, recall costs, design risk, consequential loss and so on. More than a quarter of manufacturers cited such pressures having already caused them to accept more risk. As one internal audit manager put it: “We are routinely now receiving pressure from customers whereby they try to transfer what feels like unlimited liability for the entire project. It’s getting much harder to negotiate.”
- Extreme examples of such change existed, and are detailed in case studies with the main report.
Mr Hepburn said: “The visible impact of the recession on manufacturing has been widely reported. However, there are also greater risks beneath the surface in the sector, which pose further threats to companies, investors and insurers.”
CONSTRUCTION
Research focused on companies in the £50m to £5bn turnover bracket and covered all main parts of the sector: housebuilding, commercial property, civil engineering / public works, materials suppliers and support services. As widely reported, the impact of the recession on construction has been particularly brutal, especially during the first half of 2009.
Key findings included:
- A forced diversification of work and a flight to public sector work, with nearly two thirds of respondents citing a move to new types of work or joint ventures in the face of reduced demand. This can involve companies taking on unfamiliar risks such as asbestos exposure or working in derelict buildings. It also changes contract & specification frameworks, creating a new risk management challenge. One group health & safety manager commented “Contractors are now routinely winning bids they’re not qualified to do.”
- The sector fears a second round of company failures and consolidation if public-sector demand falls through spending cuts before real private-sector recovery occurs.
- Respondents point to a vastly increased potential for contractual disputes and for companies to unwittingly take on new liabilities. Throughout the sector, contracts have become less standardised, and negotiations with both customers and sub-contractors more pressured. All respondents recognised difficulty in controlling contracts, especially with multiple desperate bidders. One in three (30%) reported specific additional liability risks already taken on.
- Intense cost-cutting has increased risks for many. Widespread reductions in health and safety spending and site supervision resource, less pre-qualification checking and ‘suicidal’ bidding practices encouraging corner cutting have increased risk.
- An unprecedented level of mothballing of existing construction sites also creates new risks around arson, vandalism and public safety.
Mr Hepburn said: “The recession has already had a brutal impact on the construction sector and continues to place huge stresses on companies within it. Desperate bidding for contracts is a particular concern, creating knock-on risks that are not fully realised.”
RETAIL
Research spanned retailers across a wide range of product segments and focused on companies with £50m to £5bn of sales. Nearly all respondents, except counter-cyclical areas and food retailing, reported major falls in consumer spending during 2009.
Key findings included:
- Retailer product risk exposure has increased, whereas in the past it has been passed up the supply chain. Three quarters of respondents cited business changes to increase this risk category: from direct involvement in product design, upstream cost-cutting outside of retailer control, refocusing on own-brand products and sourcing from lower-cost countries where liability cannot be passed back easily.
- As the insurance director of one retailer put it: “The mix of what we sell has changed dramatically. We now source extensively from the Far East… we realise that there is simply no prospect of getting money out of them [specific Chinese suppliers responsible for a large claim]”
- Like manufacturers, retailers are faced with much more fragile supply chains with greater risk of business interruption. 90% of respondents cited changes contributing to increased risk, from consolidation of suppliers and/ or distribution facilities to expanded use of ‘just-in-time’ methods.
- Credit-insurance-market contraction has been particularly pronounced for retailers, with half of respondents raising concern. In segments with few suppliers, this has particularly led to sudden liquidity demands and sharply reduced supplier choice for some retailers, increasing risk of reduced product quality.
- As the finance director of one retailer commented: “Last year no one wanted to work with us because it was impossible to buy credit insurance on our risk. As we were moving our supplier base to the Far East, we had to work with the few suppliers who agreed to sell to us. It’s far from ideal.”
Mr Hepburn said: “Supply chain risk and limits on trade-credit insurance remain real issues for retailers. When combined, as they are at the moment, they pose a much sharpened risk in the sector, especially to certain retailers. Our research suggests that we have yet to see the full impact of this cocktail of threatening circumstances.”
FINANCIAL SERVICES
The major focus of research was on medium-sized firms rather than the larger banks.
Key findings included:
- The most surprising finding was a prevailing view that business models were robust and did not need to adjust in light of recession, even when challenged by clearly increased operational risks.
- About half of respondents said their firms were simple and not exposed to new high-severity risks arising from fundamental changes in the environment. This raises fears of complacency, especially since some respondents vehemently argue this isn’t the case whilst criticising what they see as an arrogant stance by others.
- As the finance director of one asset-management company put it: “Risks aren’t changing; there are just changes in profitability.”
- However, this contrasted with a wide range of new operating risk losses raised during 2009: from breaching investment mandates to negligent advice; a lack of proper due diligence to a surge in various fraud claims. Given these, in addition to far more onerous regulatory obligations and a more volatile trading environment, it is a strong claim indeed that risk hasn’t changed.
- Companies also admit to a low level of focus on insurance risks, as opposed to higher profile ‘market’ or ‘credit’ risks. Around 50% of respondents flagged specific areas where they were unsure of the nature of the risks they run today as they relate to issues such as professional indemnity, cyber-crime or potential shareholder lawsuits against senior executives.
- There is also a marked gap between perceptions of those in the industry and insurers, who consider 2009 to have demonstrated clearly that the risks they underwrite in financial services are greater than previously realised.
- Regulatory burden from the Financial Services Authority has increased dramatically, with some respondents saying this is diverting resources from risk management.
Mr Hepburn said: “There appears to be confusion in the financial services sector. Many firms claim that the risk environment hasn’t materially changed, while at the same time acknowledging conditions that suggest it has. There may be residual complacency in the sector, despite the savage recession.”
NOTES TO EDITORS
- Research consisted of in-depth telephone and face to face consultations arranged and conducted throughout 2009 with senior financial and operational management at over 250 UK firms in the sector and size segments set out. Insurer responses comprised risk class heads and policy setters across leading London market insurance operations.
- All individual responses are held in the strictest confidence and cannot be discussed on an attributed basis.
- Mactavish is a specialist research business focused on the risk and commercial insurance segment. They have been conducting cutting edge industrial research programmes across the UK, US and mainland Europe since the early 1990s, both as independent programmes and in partnership with leading insurers, reinsurers, brokers and investment banks.
- Mactavish is chaired by John Coomber, ex. CEO and current Non Executive Director of Swiss Re (where he also chairs the Board Finance & Risk Committee). Mr Coomber alongside other roles is also CEO of the Pension Insurance Corporation. On its Board, Mactavish also counts on Paul Spencer as Non Executive Director, whose roles include Non Executive Director of WPP (where he chairs the Audit Committee) and Chairman of the Rolls Royce Pension Fund. Mr Spencer has recently retired as Chairman of National Savings & Investments for which he was awarded a CBE for services to the Financial Services industry in the 2010 New Year Honours List.
MEDIA CONTACTS
Stuart Bailey, Mactavish Press Contact on 0207 463 0638 or email stuartbailey@mactavishgroup.com
Rebecca Mill, PwC LLP Media Relations on 020 7213 5829 (mobile: 07793 680467) or email: rebecca.mill@uk.pwc.com
