Reinsurance represents one of the largest and most critical assets to insurance companies. Most insurance companies purchase a range of reinsurance protection – proportional treaties, risk excess of loss, catastrophe reinsurance, and facultative reinsurance. The successful collections of known reinsurance recoverables are recognized as essential assets. But what about those assets that are not even on the radar screen? Those that have not been correctly identified or processed? All too often, and for a variety of reasons, many millions of pounds are hemorrhaged by failures adequately to address this very question.
Over time, even the best-managed and attentive companies suffer from “leakage.” Leakage can be defined as the loss of assets through failures or gaps in processes or controls. Within the insurance industry these are manifested in three key areas:
- The under-collection of premiums
- The overpayment of direct and inwards reinsurance claim liabilities
- The under-collection of outwards reinsurance collectibles
Examples of leakages within an insurance company’s claims and reinsurance departments would include:
- Inadequate coverage/attachment analyses.
- Failure to identify or recover deductibles and retentions.
- Payments beyond policy limits.
- Errors or omissions in calculating premium adjustments, reinstatement premiums and profit commissions.
- Failing to deduct all inuring and facultative premiums from benefitting treaties.
- Inability to identify or collect from impaired or insolvent reinsurers.
The root causes of reinsurance leakage include the following:
1. Difficulties identifying all of the parties and contracts involved.
This is particularly an issue either where many years have elapsed between the purchase of the reinsurances and the continuing identification of new and potential recoveries. Over time, contracts can be forgotten, especially smaller inuring contracts and facultative protections. We are all familiar with environmental and asbestos claims that continue to be made against policies in the 1970s, 1960s and earlier. Employees who knew the rationale behind the purchase of complex programs and understood how to interpret and process unusual wordings have long since left.
Identifying all of the parties and contracts can also be a huge challenge when companies are purchased or merged. Many cedants and reinsurers will have changed names or are cloaked behind insurance and reinsurance pools and associations. The common market practice of using fronting companies adds a further layer of complexity. Evaluating the global position between each of the parties – inwards and outwards – will then be essential when it comes to offset and commutation discussions between the parties.
2. Systems and migrations
Nowadays nearly all insurance and reinsurance companies have computer systems to help identify and process necessary reinsurance transactions. There are still a surprising number of companies however who do not have integrated systems and some still use manual processes and standalone spreadsheets. Over time, a company may have introduced several new computer systems, each of which will have necessitated a major data migration exercise. It is self-evident that the more stages involved, especially those subject to human handling, the greater the opportunities for oversights and errors.
The above challenge applies within one company’s operations. What happens when several companies and/or portfolios are merged and all of the records and data needs to be migrated and integrated? The reinsurance programs will all be different, contracts interpreted differently, the technical and accounting systems will be different. Customized systems and processes may need to be introduced. This is a huge challenge that is all too frequently underestimated and often those allocated with the task do not have the time or resource to address it adequately. Corners cut will inevitably lead to greater leakage of assets, both direct and reinsurance.
3. Correct interpretation and application of reinsurance contracts
A group’s reinsurance program commonly involves numerous company entities and countless lines of business being reinsured. The contractual terms and conditions will vary over time, each subject to a number of possible interpretations. Over time, files may be poorly organized – there may be missing treaty documents, incomplete information, undocumented endorsements and anomalous transactions – making correct interpretation and application of the reinsurance treaties and inuring contracts all the more difficult.
Thousands of disputes have arisen involving the relationship between contracts, the intentions of clauses and the meaning of words. With a diverse range of possible causes contributing to inwards claims and in turn outwards reinsurance collections, the correct application of aggregation language is essential.
The interpretations within context of “event,” “occurrence,” and “originating cause” continue to be debated and contested again and again. Loss corridors and the application of coverage sub-limits, deductibles and other terms are other common sources of omission, processing errors and inconsistent procedures.
The problem is not just the complex arguments reinsurers may raise. The issue below the surface is failing to identify relevant contractual entitlements altogether. For example, ensuring that prescribed additional premium adjustments are monitored and pursued, that reinstatements premiums have all been correctly calculated and accounted for following all triggering loss events are common omissions, especially for older and legacy books of business where only the coverage details may have been recorded on automated systems.
Changes in management and personnel, sometimes without all of the required reinsurance knowledge, and ever tightening pressure on resource contribute to the difficulties in ensuring a consistent and accurate process.
4. Follow the cash!
We all know that cash is king. In reviewing any reinsurance program it is essential to follow the cash flow, the reinsurance collateral requirements and reinsurance recoverable collection procedures.
Withheld premium and claim funds, letters of credit arrangements and similar provisions are complex. Add into the mix a matrix of cedant entities and intermediaries. The potential for oversight and error in the accounting and cash audit trails are clear. Redundant reserves can accumulate over time. As well as failing to release essential capital, redundant reserves can distort the value of companies or portfolios offered for sale or commutation.
The London market and Lloyd’s in particular has been very much alive to the challenge of forgotten funds held within brokers’ ledgers and bank accounts. Only a full and accurate reconciliation can identify all of these. Brokers often have little incentive to assist because of the resource cost of identifying the potentially high volume of low value individual transactions (as well as the benefits of holding the cash!).
5. Catastrophe insurance and reinsurance
The proportional and excess of loss markets are very familiar with catastrophe events and the adjustment and payment of claims. Every event throws up its own unique circumstances and challenges. Most of these fall into two generic categories.
The first challenge is accurate data gathering. Does the cedant have effective systems and procedures for accurately recording and tracking all of its loss settlements and capturing the essential information it will need to classify claims by event, by location, originating cause, quantum and proof that these fall within underlying policies for which premiums have been received? What are the risks of losses being incorrectly recorded and either ceded incorrectly or missed from aggregation analyses?
The second challenge is that, once the inwards claims are settled within the terms of the underlying policies, which of these claims can properly be aggregated and collected from catastrophe reinsurers?
Common adjustment challenges include the categorisation of losses as either flood or wind damage following a hurricane storm surge, the use or otherwise of anti-concurrency clauses, the differing operative clauses for triggering business interruption and contingency business interruption clauses and how underinsurance is considered and addressed.
6. Leakage analysis – some real life examples
In the first example, JTW Reinsurance assisted a fellow auditing firm IRI address leakage within a US-based reinsurance operation. It had written workers compensation program business primarily containing per occurrence and aggregate limits. Our review indicated that per occurrence limits had not been correctly applied in a number of instances – such as the impact of a tornado where a loss date for one employee had been entered incorrectly and we were able to establish that it was part of the same loss (which had already exceeded the per occurrence limit). We determined that a number of claims related to a statewide power outage were not covered under the reinsurance contract. Our accounting review indicated that the company had exceeded the aggregate limits for a number of contracts, but was still reimbursing the insured. In total, our review saved the company in excess of $1 million in respect of previously paid claims.
The second example involved an exercise for the reinsurance department of a major US reinsurance company, which had acquired several companies over the preceding ten years. The JTW Reinsurance review involved researching the reinsurance contracts and premium and loss accounting records. We determined that a number of claims had not been billed to reinsurers and also that catastrophe reinsurance premiums had been overpaid because there had been no deduction in respect of business not covered by the reinsurance contract. In total, we saved the company over $2 million being actual cash receipts.
Another claims consultancy provided examples of successes it had identifying leakage of $25 million after analysing three company’s reinsurance programs. The root causes for potential reinsurance recoveries being missed included complex reinsurance arrangements and inaccurate interpretation of these, failure accurately to code and identify facultative reinsurance contracts, systemic issues with the coding of inwards claims from TPAs, and failure to aggregate smaller claims below TPA authority levels.
Remedial action – what can be done?
The range of measures to interrogate a company’s systems, records and procedures to identify leaks and make recommendations to avoid recurrence will always need to be bespoke to each company’s individual circumstances. Examples of these might include:
Identifying reinsurance assets:
- Ensuring that reinsurance programs and contracts have been correctly interpreted.
- Premiums – ensuring that all inuring reinsurances have been deducted and that premiums are deducted for non-covered business (eg. TRIA for terrorism premiums).
- Reviewing claims to ensure that all historic amounts have been included in reinsurance calculations when there is a system conversion.
- Reviewing contracts to ensure that the company’s systems are designed to recognise all reinsurance claims, particularly for older asbestos and environmental claims.
- As above and also ensuring that all historic claims values are included in any transfer to a new system and that ongoing data is in a format that will update any existing claims.
- Reviewing of contracts to ensure that permanent information is correct, including the impact of reinsurance commutations.
- Conducting a leakage review after implementation of new systems to check for missing assets.
Reinsurance asset leakage continues to damage the bottom line of almost every live and legacy insurance carrier. Like an iceberg, however, the true extent of the problem lies below the surface – undetected and/or un-quantified. Expeditions to explore below the surface require dedicated time and resource – and funding. Expeditions which senior management often chooses to ignore. But how would stakeholders react if they knew the true cost of such a head-in-the-sand approach? Could you look your CEO in the eye and assure him or her that your company has done all it could do?
Julian Ward collaborated with Derek Harris in writing this article. Derek is a chartered accountant who has worked extensively within the London and North American insurance and reinsurance marketplaces. After qualifying with Peat Marwick (now KPMG) in Newcastle he moved with the same firm to Bermuda where he was a senior auditor reviewing primarily insurance operations. Returning to London in 1986 Derek began his experience within legacy business with US F&G Re before joining a specialist audit firm assisting with a complex contractors all risks binding authority. Back within the carrier world Derek assisted Iron Trades with their reinsurance accounting systems and then Bankers Insurance as run-off manager for their Personal Accident LMX spiral exposures. Since joining JTW in 2001 Derek has specialized in complex technical accounting assignments (in particular reinsurance asset identification and recovery) and due dligence review work. Derek divides his time between our Boston and London offices.