Why Are D&O Insurance Prices Rising?
For about 10 years until 2019, the rates for Financial Lines insurances at the global markets fell to historical lows. However, the D&O (Directors and Officers) insurance market has been under enormous pressure in the past 12 months. There has been a major shift in the appetite of most of the world’s major insurers. The knock-on effect of large claims in the USA, Great Britain, Germany and Australia (high loss ratio resulting from claims filed against managers by companies with financial problems and growing costs of defending these people) is now more and more visible in local markets, although these are not yet extreme cases.
Since August, there has been an average increase of premiums of over 100% at the London market for corporate clients. In the US, the value of D&O premiums increased by over 100%, or even 200% in the case of listed entities. The UK and Germany also posted 100% growth. There has been a significant increase in the rates on excess policies, which were traditionally cheap, and so the rate of 1 per mille quickly changed to 3-5 per mille, an increase of 300% to 500% in these layers of coverage. The growth is further exacerbated by the capacity constraint problem, as a result of which many insurers have now closed their books for new business for the rest of the year. It is anticipated that this situation will only worsen with the passing of the year. Below we present some examples that confirm this pessimistic scenario.
AXA XL, which until this year was the largest player on the global D&O market, has stopped accepting new risks to its portfolio and does not want to renew existing contracts either. The insurer recently informed brokers that it did not intend to renew up to 80% of its current portfolio by the end of the year. While not explicitly stated, we assume that the insurer wants to either substantially reduce its exposure or, more likely, exit this market altogether. This will significantly lower the capacity on the market and is likely to lead to further increases in rates.
Liberty, which was the second-largest insurer in the D&O market, closed its books to new business in June. Additionally, the insurer is also said to be looking to leave this market when the head of Financial Lines left his position in May, following a reported increase in tied reserves on Financial Lines of USD 1 billion in the first quarter of this year.
We have also seen a reduction of lines by major international players such as Chubb, Allianz and AIG. Where in the past many of these insurers easily quoted risks with limits up to EUR 25 million or even EUR 50 million, they now mostly offer no more than EUR 10 million, or even EUR 5 million for primary policies. This also largely contributes to increasing the rates. While the primary insurer has until recently provided the first EUR 25 million and now much less, now the first excess layer insurer quotes the risk from the level of EUR 5-10 million and so the attachment point in the next layers is falling, which translates into a higher risk and rate. With the resignation of some players and pressure on capacity, the remaining insurers on the market are less and less willing to negotiate the offered terms, especially with new clients.
In short, the situation has to worsen significantly before it gets better, and if we see Liberty or AXA XL officially withdraw from the market, it will additionally create serious pressure to increase rates. These two players are always seen as trendsetters in the market due to the size of their portfolios.
However, it would be too simplistic to explain the rising insurance rates solely with the poor loss ratios in other countries. To fully understand this phenomenon, one has to go back to the 2008 financial crisis, which was followed by a significant drop in interest rates in key financial and currency markets (US, Eurozone and UK), which led to limited or no return on previously profitable government bonds. This has led investors to seek another outlet for their capital where they can profit outside of the capital markets by lending and direct investment. During this time, the insurance market achieved return on equity (RoE) rates of around 15% and enjoyed a relatively golden period of stable rates and few natural disasters (which actually determine the international market situation). Investors saw this and were ready to provide surplus capital to insurers to allow them to carry out more transactions. The capital surplus and a small amount of claims contributed to enormous competition, which in 2019 led to the rates in D&O insurance in some cases even up to 0.5‰, while in 2010 the average market rate was approximately 0.3‰.
Loss ratios that have been deteriorating since 2019, which were influenced for example by poor risk selection (forced by competition), caused the rates of return on capital to drop to single-digit values, and investors began to look for a safer place for their capital than the Financial Lines insurance markets. Such are, for example, more traditional insurance markets (e.g. property), which are easier to model.
Along with less capital, insurers cannot offer the existing capacity at D&O, and in fact, dictate the price for the capacity, not for the given risk and the number of clients they can provide coverage drops, and therefore prices rise.
To understand why capacity matters, we need to look at how capacity is allocated in an insurance company at the London market, which is both a trendsetter and a reinsurer for other smaller markets. At the beginning of the year, the insurer will use certain tools to allocate a maximum income to each line of insurance. This depends on a number of factors, most of which are highly theoretical.
They will first look at the available capital from investors and reserves. This is allocated based on the lines of insurance and possible premiums from those lines. The cost of capital is a key part of this process and is fundamental to insurance pricing. Each line has to allocate a portion of its income to a pool that will be used as a guarantee to cover claims from all policies. This is a complex process that we won’t go into here, but it does create a minimum quote to make it profitable (it’s actually an imputed premium fee). If prices fall below this value and no claims are reported, it doesn’t really matter, but in a claim-abundant environment, it does.
After analyzing the above, the insurer’s actuaries will make the allocation based on the previous years and the probability of earning a profit in the coming year. Rarely do the arguments of individual teams have any relevance here, especially if the actuaries believe they will suffer a loss.
After this process is complete, each team will have its maximum income determined, but so will the insurance company. Since they have to prove to the regulator and credit rating agencies that they can absorb their losses, they cannot change this final amount too much. Companies such as AIG or Allianz have more room for maneuver here, but it is still limited. So, if the D&O team has an income cap of what they made last year, then increases will mean they will have to select risks or, more likely, lower their line for each risk they have.
The main reason for the rise in D&O insurance prices is therefore the profitability of this product. This is not only the result of the loss ratio, but above all, too low prices and an ever wider scope of coverage. Yes, the market was shaken by a few major claims, but they would not have changed the market by themselves. The prices simply fell to such a level that they significantly influenced the perception of the profitability of this line of insurance.
Analyzing the situation in Central and Eastern Europe, we do not think that this part of the insurance market will escape the trend. Germany is already feeling serious problems. The Polish market always reacted with some delay to global trends, but we are also not strong enough to resist these problems. There is a visible more conservative approach of our underwriters who ask more and more questions (including how the COVID-19 pandemic affects the functioning of the company) or apply more and more exclusions, especially regarding bankruptcy or lack of financing. New customers from industries particularly affected by the economic crisis (especially production companies dependent on foreign supplies of components; clothing manufacturers / distributors; shopping malls; gastronomy; tourism, including aviation business or hotel industry; organizers of mass events) cannot count on the D&O insurance offer at all. The increase in rates is already visible on high risks requiring the involvement of facultative reinsurance from foreign markets. The SME market will also be affected by changes with the entry into force of new treaty contracts.
Therefore, we should not be surprised if our market (which, when analyzing statistical data, seems to be three quarters behind the London market), will also see a 15-20% increase in rates without claims. Customers with reported claims should expect increases of at least 50-100%. It should also be taken into account that London underwriters currently forecast a loss ratio of 75% in the financial year, which means that prices are at 30% of the relevant premium. This tells us, that we will be seeing the hard D&O insurance market for a long time.
Piotr Rudzki, Financial Lines/Financial Institutions Practice Leader, Broker Ubezpieczeniowy i Reasekuracyjny in GrECo Poland
Last Updated on December 15, 2020 by Karolina Ampulska