The reality of reform – how will the industry look and feel?

Nick Prettejohn, Lloyd’s CEO

7 April, 2005, UK — Mr. Prettejohn addressed the FSA Insurance Conference about the challenges facing the general insurance industry.

“Strategic” is an overused word.

Sometimes “strategic” means not soiling yourself with facts, but dealing only in aspiration, as in “Strategic awayday”.

Acquisitions that are “strategic” are those for which one is about to overpay.

“Strategic” can be employed as a euphemism, as in “strategic withdrawal”.

And sometimes it is code for “plain difficult”, as in “Strategic Rail Authority”.

I am not sure that the challenges that I am about to discuss for the general insurance industry are necessarily “strategic”. But challenges they certainly are and you can apply whatever use or misuse of the word “strategic” to them that most appeals.

For those of you who have had the misfortune to have heard me speak before, I have only a limited set of themes which I tend to repeat. To paraphrase the words of the late Ronnie Scott, I would play some more tunes, but I don’t know any.

I am going to describe six challenges to you. They are not – I should stress – a comprehensive list.

  • Stop destroying value. Change the habit of a lifetime. Make a profit on underwriting on more than an occasional basis.
  • Change behaviour so that the process of doing business is radically improved.
  • Use technology to multiply the positive impact of changed behaviour.
  • Compete successfully for talent versus other industries that have historically been seen to be almost infinitely more sexy, and then nurture and train that talent.
  • Engage with society and government – and learning from Prince Charles, relish the engagement.
  • Extract all the benefits from regulatory change, and minimise the costs.

Six challenges. Let me discuss each of them in turn.

First, make an underwriting profit on more than an occasional basis.

I speak to you in the aftermath of an historic year. In 2004, the US Property and Casualty industry made an underwriting profit. A combined ratio of below 100; the twitchers amongst the general insurance world have been treating this like the appearance of the golden eagle. The first underwriting profit since 1978. I continue to find this an extraordinary statistic, one that becomes more and more extraordinary as I repeat it.

In our industry’s own parlance, underwriting profit has a return period of 25 years. Shortening that return period for underwriting profit has to be the major challenge for our industry.

It is not possible for the industry to make an adequate return for its shareholders unless this happens. The arithmetic simply does not work. You have to earn a return on underwriting to make a return on capital that is equal to or greater than the cost of capital. If you don’t, then you are destroying value, which is what the industry has been busy doing for the last quarter of a century.

So by any stretch of the imagination this is a necessary challenge to meet. How to do so? A few suggestions…

Stop talking about the cycle as though we are utterly powerless in the face of some all powerful dialectic. No one can deny the existence of the insurance cycle, but it is not an alibi for management inaction.

Resist the temptation to grow, succumb to the need to prune. Sadly, this will involve a continuing and intensive re-education programme of the capital markets as well as corporate management.

Develop the ability to discover and confront unprofitable areas of business as early as possible. The industry’s inability to know the cost of its sales on a timely basis is a major weakness.

Make return on capital the single most important performance measure for underwriters as well as investors. More than a happy coincidence.

Ensure that management and underwriters are fully connected. The best businesses at Lloyd’s are those where underwriting excellence and general management strength have the shortest communication lines.

And (less practically I admit), discourage the capital markets from over enthusiastic support of start ups when rating conditions are positive. Capital finds it easier to get in than to get out especially when the going gets tough.

The industry must, then, face up to the challenge of making an underwriting profit – for our shareholders, to justify their investment, and for our policyholders, to generate the financial strength and stability they expect.

This is all about behaviour – an effort of will by management and a translation of that management will into transaction by transaction vigilance. It is the single most difficult – but the single most important – challenge that we face.

My second challenge is also about behaviour – radically improving business process.

Why is improving process important?

Because it can lower cost; frictional cost in the industry is simply too high – especially in a business where making an underwriting profit seems to be inherently difficult task.

Because better process produces better information. Better information can produce better decisions – decisions about underwriting, decisions about capital allocation, decisions about risk management, decisions about process management itself.

Because better process means better service to the policyholder.

Because better process enables greater transparency, which give greater confidence between trading partners, to management and Directors, to shareholders, to regulators and to policyholders. Insurance is all about confidence, so transparency is essential.

When people talk about process change they sometimes, automatically, “think technology”. This is wrong.

Systems don’t create process change; businesses, working with their trading partners, create process change by agreeing how to behave and what standards to adopt. Then they use systems to support that chosen behaviour and enshrine those standards. And obviously the fewer the number of systems, the more harmonised the behaviour and the easier it is to enshrine standards. But without changes in people, management attention and behaviour, technology cannot unilaterally achieve change.

A few examples.

Claims management is a critical area for the industry, both an efficiency and, clearly, a service issue. Given that it is at the heart of the industry’s promise to the policyholder, it has never been accorded the degree of senior attention that it deserves. At Lloyd’s we are introducing minimum standards and principles for claims management that elevate claims issues to the boardroom.

Then there is the topical issue of Contract Certainty. Always necessary, of course, to acknowledge that contracts and certainty do not go automatically together. Generations of lawyers have the collections of vintage claret to prove it.

But the concept that key terms and conditions and wordings should be agreed at inception, and documentation issued at the latest in short order thereafter, but preferably also at inception, is a reasonable starting point. The FSA has set us a demanding deadline to register meaningful achievement – the end of 2006, which effectively means that we have to demonstrate real progress by early 2006. We are under no illusion about the seriousness of this deadline.

Central to making the required progress is achieving a proper practical definition of contract certainty and specifically the attributes that define it: for instance, wording, law and jurisdiction and so on.

For the London Market, we are developing measurements, and programmes of action, based around nine of those attributes.

And the London Market Principles slip is the cornerstone on which we will build.

Now, the LMP slip structure is nothing more than a set of headings that demands the supply of information A simple step towards contract certainty because it is documenting upfront the key data about the substance of a transaction. All about behaviour. And at least I can report that the effect of Lloyd’s mandating the slip earlier this year has resulted in 93% compliance, short of our 95% target but encouraging nonetheless.

What is less encouraging is that the LMP slip structure took several years to agree. And only 22% of slips are actually perfect. In manufacturing businesses it is those – and perhaps only those – who get it right first time who win.

There is nothing very technical about an LMP slip – it is all about having the inclination and the discipline to agree a specified number of things and record them at a specified point in the transaction.

This requires behavioural change by all the parties involved in a transaction – by underwriters, by brokers and by policyholders and their risk managers. All should resist the temptation to compress the period of negotiation in the hope of getting better terms and conditions, or temptation to tolerate ambiguity because it may prove advantageous at the point of a claim. Those behaviours are obstacles to the achievement of contract certainty.

The other behavioural change I would single out in discussing our business process is disclosure of commissions.

My previous remarks on this have been well aired and I will not bore you with a blow by blow repeat. But I remain, convinced of three things. First, we should have full and – yes – mandatory disclosure of commissions.

Second, we should acknowledge that what is being disclosed is where and to whom the money that the policyholder has paid is going.

And third, that disclosure is essential if we are to tackle the challenge of rationalising the business process, because it provides everyone with the economic facts on which to base management decisions to generate greater efficiency.

When you add the positive effect disclosure has on confidence – and to repeat, insurance is about confidence – the case for full disclosure becomes overwhelming.

So behavioural change is core to the improvement of our business process. Improvement won’t happen without it.

Now, change behaviour successfully and the results of that new behaviour can be recorded via any medium you like. The results will still make a real difference. But technology then gives you the ability to get the most out of behavioural change, and to enforce it.

That leads me to my third challenge. To use technology to multiply the positive impact of changed behaviour.

With this in mind, let me describe a vision of the future that seeks to leverage the power of today’s technology. This vision has four key components:

  • simplified, harmonised business processes involving the multiple exchange of
  • standardised data through
  • structured electronic messages organised by
  • community platforms which minimise interfacing costs and enforce discipline

In my simple layman’s conception this vision means having the equivalent of an accepted language, accepted grammar, designated dictionaries, notice boards and libraries, and a common postal system. In everyday life these things are hardly the enemies of individual thought except, I suppose, in the mind of a superannuated Dadaist. Nor should anyone argue that realisation of this vision will eliminate underwriting and broking creativity.

Just as language, grammar and so on provide the means for the most glorious examples of individual expression, agreed processes, standardised data, electronic messages and community platforms can provide the infrastructure upon which creative trading can flourish.

So let’s explore this vision a little further.

Brokers and underwriters negotiate face to face, on screen, or both, while exchanging data, and recording the progress of their transaction, through a collaborative electronic system or systems that reflect the placement process.

The structure of the data that is exchanged will have been agreed in advance, and its structure and content will conform to international standards that the broker and the underwriter employ in their businesses the world over.

In the subscription market the systems will generate a slip. They will enable, as the broker and underwriter chose, one of the parties, or a third party, to produce a policy. That policy will be based on standard wordings accessed from the wordings libraries of either party, with changes from those wordings tracked and audited electronically. Or, if necessary, a wholly bespoke wording can be created, again in an auditable process. Or the slip can serve as a record of the contract, if sufficiently comprehensive in scope.

The placing system or systems will retain the data and the process audit of the transaction, accessible to broker and underwriter.

The notification and management of claims will be similarly supported by international standard messages to transmit data and initiate claims management actions. And supported by claims repositories, to store data relevant to a claim (including the slip, for instance) and to enable simultaneous and controlled access where appropriate for the parties to the transaction.

So, in this vision, systems support the human activity of front and back office, to enable brokers and underwriters to enter data once, have real time access to that data, and to have a secure auditable record both of the substance of the transaction and the process that generated it. And businesses will use that data to improve process management.

Systems will interface directly with one another or through a hub. On the one hand trading partners will recognise that different parties and combinations of parties own and invest in systems that create and use data at different stages of the business process. On the other they will also recognise that the price of multiple interfaces is too high, and will use a community hub to perform that interface function. Or they will use the same collaborative systems.

They will not all insist on using their own systems all of the time, and therefore on having to interface individually with the systems of all of their partners. Such an insistence would be expensive. It would also ignore one of the other major benefits of community platforms – that common standards are easier to enforce using common platforms.

That, then, is the vision. The major systems initiatives in Lloyd’s and London are consistent with this vision. To repeat none of them are panaceas. All of them rely on changes to underlying behaviour and the devotion of management attention.

Technology has the power to be a great enabler in business process. It can also transform our ability to assess risk. Not just through sophisticated modelling techniques on which we now rely and which have been tested – for the first time really, and quite pointedly – by the recent Florida hurricanes. But also finding, assimilating and analysing risk – based on internal data (how many of us can truly say we use more than a fraction of the data we generate?) and external information – and most powerfully the cross tabulation of internal and external data.

Which brings me to the fourth challenge: Compete successfully for talent versus other industries that have been seen to be almost infinitely more sexy.

You need bright people to get the most out of data. You need creative people to assess risk.

September 11th, the Florida hurricanes and the Tsunami were reminders that the world is an uncertain place. Our industry is a reflection of the world around us. That world is an unpredictable function of great and small individuals, huge impersonal economic and political trends, technological change, and chance, to name but a few. We have to assess the riskiness of it. Fascinating. And we need to use all the techniques at our disposal. Above all, we need to have the people with the breadth of intellect to take on the world and its issues – to understand and value them.

That means we need to compete with the investment banks, the consultancies, the law firms, the accountants, to get the best brains into our business.

We need people who can think creatively, who can think analytically, who are quantitative, who are imaginative. Because – without wishing to sound too portentous – we are thinking about insuring the world and what goes on in it.

Not just natural disasters. But how industries and the businesses in them work, and what risks they generate. And then how to anatomise the price of those risks. People who can understand Enron, the boom, the risks of technology and pharmaceutical companies, of accountants and doctors and charities. Who can understand that risk is a function of the world we live in.

The industry should be much more confident and imaginative in its appeal to potential recruits. What we have to offer is significantly more interesting than many of the potential employment avenues that bright people chose.

We should certainly actively promote diversity – because it is right to celebrate talent always above type or origin, but also because it makes pragmatic business sense to seek ability from the widest possible population.

And we should ensure that the training we offer and require reinforces the behaviours that we need – in the context of the London Market, the work of the new CII London Market faculty would be a good example.

General insurance requires deep technical expertise in many aspects of what we do. In the past technical expertise has been, sometimes, an alibi for introversion. Insurance has been and remains an introspective business; ironic, given our mission in life. We can learn much from other businesses – whether from the capital markets in their ability to produce contracts for highly sophisticated and complex transactions at point of agreement, or from manufacturing businesses who have learnt to get it right first time.

Ridding ourselves of introspection is essential if we are to meet my fifth challenge – to engage actively with society and governments.

The boundaries of risk are being constantly redefined by society, and especially the legal system. Governments, judges and juries define a substantial amount of the risk that is assumed by our industry. The most spectacular examples of this come from the United States where the tort system costs an increasing amount of money so that it is now an appreciable (around 2%) proportion of GDP. A disturbing benchmark for a world that tends to follow US trends.

The legal and legislative system can be a real creator of risk.

Laws exist because governments make them. The judiciary interprets and applies the law – in doing so the judiciary also makes the law.

In today’s world, given its complexity – complexity produced by social, economic, political, random factors – governments have an almost hyperactive tendency to intervene.

Governments can’t resist the temptation to intervene where they think they can see evidence of market failure. “Failure” defined as a situation where the government thinks it can do better than the market mechanism; and “failure” also defined as the (in fact totally unsurprising) imperfect reality of actual markets versus the conceptual ideal of the perfect market.

Governments are driven to intervene by interest groups, as well as by ideology. They make law, they change law. They seek to stop things from happening, or to make them compulsory. The courts then translate those laws into liability.

Without extreme care, and sometimes despite it, what you believe you are insuring today may not remain a constant in the years to come. The goalposts, and sometimes the whole pitch, move. We have seen this from government and courts time and again on environmental liability, personal injury, employers’ liability and so on, in the UK, Europe as a whole, and the US.

Because government plays such an important part in determining risk, we must excel at dealing with government. In particular we must educate government about the cost that comes from changes to, and hence the underwriting consequences of, the legal framework under which we operate. In order to do this we must invest. A couple of years ago I heard somewhere that the insurance industry spends $3.5 million in California on government relations and public affairs. Trial lawyers (apparently) spent $3.5 million on the governor race alone, 87 times more as a proportion of revenue.

The only way we can maximise the potential for governments to do the right thing is if we engage actively with them.

I would agree that a healthy scepticism about governments is a good starting point for our dealings with them. But we should never let that scepticism translate into reticence or, still worse, hostility. It has been Lloyd’s privilege to work with some outstanding and constructive people in government, and open, friendly dialogue can result in real progress. In recent times our own government’s actions in agreeing to change the tax treatment of Names converting from unlimited to limited liability and in arguing the case for free trade and open access to markets are good examples of what can be achieved.

Given the attention that Spitzer and others have brought to our industry it is clear that, as an industry, we will have to work hard to ensure that government’s paymasters – the electorate – have a more positive view of what we do.

We are an easy industry to criticise and blame when things go wrong, despite the reality that what we do is to enable individuals and businesses to operate from day to day with crucial protection against the financial impact of fortuitous events.

So when we have the opportunity to embrace a change which reinforces public confidence in us, such as on the commission disclosure issue, we should grasp it.

Actively embracing change, actively engaging with others. That brings me to my sixth and last challenge, the challenge of extracting the benefits from regulatory change, and minimising the costs.

To be successful in financial services today, you have to be outstanding at many things, but I would suggest that working effectively with regulators and their requirements is clearly one of them.

This may sound like a banal insight born of a desire to toady to our hosts and organisers. It is not. Rather it is a plea that we invest to integrate regulatory requirements into our business, rather than treat them as a disembodied task.

It is an extension of my concern about the concept of “Risk Management”, about which I have some doubts. Not because I think that the issues handled and disciplines enforced by Risk Management are unimportant. Far from it. Rather, my general observation is that once an activity in business becomes a designated corporate function, it risks a number of things happening.

First, it risks losing touch with the business for whom it performs the function. The function acquires a life and a language of its own.

Secondly, everyone else in the organisation can sometimes blithely assume that they don’t have to worry about the issues encompassed by the new function. Everything will get taken care of. No need to worry about them anymore. “They” are taking care of it.

Third, when this newly created function and the rest of the organisation then do have to interact even, or especially, around a critically important issue, the result can be incomprehension, frustration and worse.

These risks do not reflect in any way on the importance of the function concerned. Indeed, there could even be an inverse correlation.

In corporate life, I am sure many of you will have seen this syndrome at work with the IT and strategy functions.

And I believe there is a risk it can be true of Risk Management. Everyone knows that Risk Management is important. And I am tempted to put “important” in “1066 and All That” capitals and inverted commas. This is particularly the case in today’s compliance driven environment. So, give it a title and a separate department, and we are off to the races. The Risk Management team can now do their thing, and we can all relax. The Directors and the Regulators are happy.

This is clearly a caricature. But it is rooted in my genuine concern that Risk Management should avoid the pitfalls that IT and strategy functions all too often fall into.

“Risk Management” should really be redesignated “Good Management”. When you strip away the regulatory and consultant jargon, it means understanding what could upset your business, figuring out how worried you are about it and taking the appropriate preventative action.

In the same way, there is no point in regarding regulatory requirements as an inconvenience that must be compartmentalised and kept separate from the day to day running of the business. Those regulatory requirements must be fully integrated into the management fabric of the business. Nowhere is this more obviously the case than in assessing risk and translating that assessment into the capital requirements – the Individual Capital Assessment process that the FSA has introduced and which is consistent with the general thrust of Solvency 2.

At Lloyd’s we are engaged in the process of replacing our risk based capital setting system with a new system driven by the ICA’s of the individual businesses in the market. This transition is in itself a tough and intensive one. Judging from the amount of work required to generate an ICA, it is essential on cost grounds alone for the businesses to integrate the ICA process, and the output from it, into their management process. To expend such an effort and not to do so would be a waste of resources, a waste which would – wrongly in this case – perpetuate the notion that all regulation does is to create incremental cost.

But such an integration is actually imperative because the disciplines of the ICA process are the disciplines of good management. Understanding risk and how to control it, defining your appetite for it, and then working out how much capital you need to have against the risk you chose to take. These are basic management disciplines not “basic” meaning “easy”, but “basic” as in fundamental.

The incremental cost of regulation can be minimised not only by self restraint, and a resolutely risk based approach, on the part of the regulator, but also, in part, by the actions of the regulated.

This is not an open invitation to more and more regulation. With my FSA Practitioner Panel hat on, we are acutely conscious of the need for the cost of regulation to be appropriate to the task and especially so in sectors where businesses have the ability to move capital and business between jurisdictions.

Nor is it an open invitation to load more and more responsibility on senior management in the absence of well focused guidance. Practitioners right across financial services are concerned about regulatory guidance. The right quality? Too much? Too little? Getting the balance right between market driven solutions and detailed guidance is not an easy one.

But I agree with Robert Hiscox that sometimes, specific guidance is needed on important issues. It would save time and money because in the absence of guidance, practitioners take expensive and often fruitless legal advice. And targeted guidance can reinforce and catalyse the commercial process of change. As an industry, we should work actively with regulators in their difficult task to achieve that right balance.

So, six challenges. NOT, as I said at the outset, a comprehensive list.

  • Achievement of underwriting profit
  • and Business Process change
  • Use of technology
  • Competition for talent
  • Our relationship with society and government
  • Management of regulatory change

All of the challenges have to be met in a more complex and ultimately riskier world than the one in which we started our working lives. Which means getting our house in order is all the more important, because our underlying task is getting more difficult.

And we are having to perform that task under greater and greater scrutiny – corporate governance scrutiny, regulatory scrutiny, accounting scrutiny. Again, not easy, not least because at the heart of our business lies the reality of estimation. We estimate every day – to set reserves, to set prices. Getting people properly to understand the reality of estimation is essential. Especially when changes in accounting requirements will make the process of estimation potentially even more complex for outsiders to understand, and the output of that process more volatile.

Against that background I take it as good news that the challenges I have discussed seem to revolve so much around changing behaviour and attitude.

  • Disciplined behaviour in underwriting
  • Changed behaviour in business process
  • An open and realistic attitude to technology
  • An inviting and inspiring attitude to talent
  • Engagement with government and society
  • The integration of regulatory needs into management behaviour

The biggest strategic challenge we face, therefore, is ourselves.

And it was ever thus. But the external pressures upon us to meet that and the ensuing challenges are now considerable. Those pressures come from a number of sources. From capital that is mobile and demanding; the capital markets will be increasingly intense in their scrutiny and I believe, less, tolerant of poor performance. From policyholders who want stability and transparency. And from regulators and enforcement agencies who will be unyielding in their scrutiny.

Those pressures must be channelled constructively, so that they improve performance and confidence, rather than increase cost. We shouldn’t need their help to succeed, but help us they can and should.

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