Fixed-premium Marine Insurance

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Protection & Indemnity (P&I) Marine Insurance

The marine liability insurance industry has been dominated for over one hundredfifty years by a system characterized by the mutual sharing of the risks of shipping and shipowning.  Based on the principle of having no share-based capital, membership signifies not only being a risk-incurring assured, but also an insurer liable for paying a proportion of all losses incurred by other assured members. For the majority of vessels trading internationally, over 90% of the world’s merchant fleet marine pollution and third-party liability insurance is provided through Protection & Indemnity Associations (known as P&I Clubs), which are wholly-owned mutual insurance cooperatives of shipowners.  In the P&I Club structure, members pool their funds to provide coverage for liability[1] in exchange for payment of an initial levy, or advance “call” for premiums, followed by supplementary calls for the remaining premium plus any additional funds needed to cover losses.  This funding of losses “post hoc” allows shipowners to spread the cost of their coverage over a period of time, an attractive feature in times of tight profit margins often found in the shipping industry.  Supplementary calls for funds are made of members belonging to a Club during a specific policy year.  If claims for that year exceed both the initial advance premium calls, calculated supplementary calls, and reserves on hand (the accounting year is not « closed » until all claims have been filed and accounted for), then an additional supplementary call is calculated as a percentage of the original premium amount charged of each member.  Call history has ranged from a low of –10% (refund) of the initial advance call to a high of 240%.  It should be noted that until the 1996 policy  renewal date, non-pollution marine liability insurance had no liability limit for P&I Club members; i.e., potential supplementary calls for members also had no limit.    The International Group of P&I Clubs currently consists of nineteen members providing coverage for over 90% of the world’s blue water (ocean-going) tonnage.  It provides a legalized, non-competitive cartel for the pooling of insurance claims, and for the collective purchase of reinsurance (insurance for insurers), the largest reinsurance policy in the world, which covers claims above a predetermined amount. Coverage for claims is layered and beginning with the 1999 policy year (beginning 20 February5), all group members share claims in excess of the first $5 million retained by each club.  The upper limit of this pooling agreement or layer stands at $30 million, and claims over that figure would be paid by reinsurers up to $500 million, with the Group retaining a 25% deductible.  Above the $500 million layer, non-pollution claims are reinsured 100% in London on the commercial market, up to $2.03 billion.  Finally, any catastrophic claim in excess of the upper reinsurance limit reverts back to the Group for payment in proportion to each club’s total entered tonnage.  This liability would actually be paid in proportion by each member, based upon their respective tonnage, albeit limited to the sum of 2.5% of the combined property.  In other words, the limitation of each Club stands at $2.25 billion plus approximately $2 billion, after adding reinsurance and pooling agreements, for a total liability cap of $4.25 billion.  There is an exception to these sums for liability for oil pollution, which has a cap of $1 billion per occurrence and requires additional premium payments on a per voyage and gross tonnage basis for each vessel covered. In 1985, the European Union granted a ten-year approval to the price-fixing mechanism that allowed a Club to charge the same premium rate for one year as was charged by a previous Club for any vessels switching P&I Clubs.  This reduced the  possibility of exposure to moral hazard6 from unscrupulous shipowners; for example, switching a vessel that had failed a survey or was in need of expensive updates to another Club when the original Club thus required a higher premium to maintain the vessel’s coverage.  In 1995, this policy was reviewed and, according to new thinking by EU Maritime Commission members, was determined to be monopolistic pricing which stifled competition to the detriment of the consumers, the shipowners.  The International Group protested, claiming that instead this pricing method protected the new Club from the moral hazard of unknown exposures, while protecting the old Club from unfair membership losses due to predatory pricing.  A ruling by the EU Maritime Commission was made in 1996, however, that the current pricing method would be allowed to stand for another ten years, on condition that the Clubs remove all administrative costs from premium calculations.  These were published separately on their annual reports beginning with the 20 February 1998 policy year, thereby providing a better method of comparison for shipowners in choosing Clubs. The Club system has always been a closed system with little information available about its operations.  The spotlights focused on the Clubs by the EU and other international forums in the past decade, and the influence of the P&I Clubs in reducing ex ante moral hazards of covering sub-standard vessels, however, have also brought increased attention to its financial structuring.  In fact, Standard & Poor’s (S&P’s) only began rating P&I Clubs in 1994.  In this new endeavor, they had difficulty in accommodating supplementary calls from members as a measure of solvency, given that this method of reserves is entirely dependent upon the financial health of individual shipowners for which no financial data was provided.  Strictly speaking, a Club could be technically considered financially insolvent at any one period in time because of its dependence on future supplementary calls to cover current losses. As a result, initial low ratings were given by S&P’s in 1994 to those Clubs with the greatest dependence on supplementary calls, which led to a general tendency to increase Although the current oil pollution liability limit for P&I members is $1 billion arising from any one incident (including collisions between vessels), an additional $500 million in reinsurance (insurance for insurers) is available commercially on the London market.  Other non-pollution liability was unlimited until recent years. The International Group of P&I Clubs fiercely debated the feasibility of instituting a limit to non-oil pollution claims, almostleading to a break-up of the 150-year old system. A pooling agreement allowing for a $20 billion ceiling to liability exposure for each club member was adopted in 1995, and would cover any catastrophic claims above the group reinsurance contract.  This figure has since been revised downward to a maximum ceiling of $4.25 billion. Reserves on deposit.  The Clubs’ free reserves (as opposed to reserves for claims incurred but not yet reported) now stand at an estimated $1.8 billion, up from just $0.5 billion a few years ago.  This step, contrary to Club tradition, was taken in order to improve S&P’s ratings and attract “quality” members, i.e., those with a lower risk profile.  The thought of decreasing both the necessity and quantity of supplementary calls for claims for all shipowners was the driving factor behind this change. In 1998, the S&P’s Report on the P&I Clubs for the first time stated that the influence of member financial viability was a factor in determining the rating of the Clubs.  It included a rated sampling of shipowners in order to establish a baseline for each Club, while changing their rating scheme to a lettering system similar to that assigned to other financial institutions (A+, A, etc.).  This more transparent rating undoubtedly benefits the stronger Clubs at the expense of the weaker.  In fact, the mutuals have recently experienced some significant changes:  the purchase of a smaller Club by a larger one, the merger of two of the largest Clubs, the demutualization of one Club (conversion to a fixed-price entity), and the bankruptcy of a marginal Club due to reinsurance disputes, all signs of the increasing volatility in the industry.  This instability, combined with the rigidity of the Clubs in insisting on elevated liability limits, added to the increased realization by shipowners that they are ultimately the underwriters for the Clubs’ solvency, subsidizing others’ losses.  The entire market became more open to potential competitors working outside the mutual traditions by offering fixed-premium coverage, an attractive feature for quality shipowners.

Fixed Premium Marine Insurance

In the marine liability insurance market, fixed-premium underwriters have come and gone over the past several decades, never getting beyond establishing a token presence.  Several factors have hampered the existence and growth of these companies:  their policies offered only low coverage levels, payment of premiums was required up-front in a lump sum, and they lacked the capacity of furnishing additional customer services such as those offered by the P&I Clubs to their members.  The first factor guaranteed that most shipowners’ potential liabilities could not be fully covered, while the second caused shipowners operating on tight profit margins to prefer the periodic payments of the P&I Clubs.  Finally, the last issue meant that services required in normal ship operations were lacking, such as filing letters of undertaking to avoid an arrest of a ship or having local representatives handle claims in exotic locales.  The fixed-price underwriters could not compete with the Clubs over the long term with those shortcomings and either withdrew completely from the market or limited themselves to occupying only a small niche.    Downward trends in claims in the mid-nineties however, combined with an excess of underwriting and reinsurance capacity, led to what is known as a “soft” market.   For example, lower premium incomes produced in other lines of underwriting (non-marine) caused traditional underwriters to search for new business lines to provide other sources of income.  This encouraged them to attempt a new offering of fixed-premium marine liability coverage to shipowners during a period of low losses.  These efforts were mostly backed by large reinsurance and insurance companies such as Underwriters at Lloyd’s and Terra Nova of Bermuda.  And these large companies, for the first time, permitted upper policy limits that approached or equaled the $1 billion limits found for oil pollution liability, thereby offering a realistic alternative to the Clubs on this essential point.  This was especially attractive for shipowners not wishing to be exposed to the larger risks of belonging to a Club.  In fact, the 1998 policy year renewals saw some $50 million of premiums being placed with fixed-price offerings, thus representing approximately 5% of the market share  being lost by the Clubs.  In that year, eight fixed-premium facilities offered liability coverage to the marine market, with AXA of France entering the market in September 1999 as the last new addition to the group.  By the end of December 1999, the fixed premium market had around 7 million gross tons of vessels covered, which, although not a tremendous amount in global terms, still represented a high-water mark in historical terms of competitive strength with the P&I Clubs. The lack of the threat of supplementary calls was another attractive feature of the fixed-premium underwriters, especially in the recently depressed shipping market, which has so depleted shipowners’ coffers.  And while not offering the same level of auxiliary service as the P&I Clubs, with rates remaining competitive in the soft market in 2000, they were seen as an attractive alternative to the mutuals.  In fact, the combination of declining premium rates seen until September 11, 2001 and declining investment income was a major reason their entry into the marine liability insurance market represented a significant threat to the P&I Club structure.

Literature Review of Insurance Pricing Models

A common approach found in insurance valuation modeling is one where variables measure past performance in order to account for the uncertainty of present and future costs.  For example, past liabilities must be measured (usually in present value terms), because they may deplete available surplus if they exceed premiums, thus playing an essential role in determining the amount of insurance capacity, or risk, that an underwriter may assume in the future.  Another problem facing underwriters involves the uncertain cash flow received over time from premiums.  This also affects surplus amounts and the assumption of future risks, because any catastrophic loss would quickly exceed past premiums received and might necessitate use of current income.  In addition, capacity is affected by market risks:  varying interest rates received on invested assets and reserves, inflation rates, and exchange rates, all of which influence future risk assumption because they affect premiums, claims, and surpluses held. Some of these problems were addressed in a 1993 paper by Ronald Chung, Hung-Gay Fung, Gene C. Lai, and Robert C. Witt, entitled “Causal Relationships Between Premiums and Losses, and Causes of the Underwriting Cycles”, which dealt with the property-casualty insurance industry and the cyclical nature of underwriting returns.  This paper used a vector autoregressive model to test the relations between premiums and losses as well as to test how premiums responded to shocks to selected variables.  Premiums were stated to be a function of past premiums, past losses paid, aggregate policyholders surplus, the five-year Treasury bond rate at time t, the conditional variance of losses paid at time t, and the conditional variance of interest rates on treasury bonds at time t.  The results of the regression using this model found that insurance premiums indeed responded to shocks to the variables studied, although within the boundaries of the rational expectations theory with an institutional lag hypothesized by Cummins and Outreville that provided a basis for the analysis. In a 1994 paper, “Adverse Selection in an Insurance Pool”, Bruno Biais and Christian Gollier discuss a variation on the Rothschild-Stiglitz equilibrium model for insurance to account for adverse selection.  They describe equilibrium in a competitive market (assuming perfect information, free entry and identical risk adverse consumers) as one where insurance contracts earn zero profits.  In Rothschild-Stiglitz Lecture Notes, the equation for the supply of insurance contracts is thus written as follows:  the probability of loss p is worth π(p, δ) = – (1-p) – δ1 – pδ2 = – δ1 – p(δ2 – δ1) = 0, where δ1 represents the premiums and δ2 the losses paid on a claim.  In equilibrium, π(p, δ) =  0, known as “fair” insurance, is where the available contracts fall along the fair odds line where the slope equals 1-p/p.  Adding asymmetric information in the form of both low-risk and high-risk customers, the market adapts by creating either a pooling equilibrium in which both groups buy the same contract, or a separating equilibrium in which different types of coverage are available to each group.  As described earlier, we’ve seen that the P&I marine insurance industry offers a pooling contract with minor differentiations based upon the premiums charged for each class of risk (e.g., vessel type), while the fixed-price underwriters provide a low-cost contract to only one group, the low-risk one with related lower loss profiles.  But the basic underlying operating premise remains the same for both, as shown in this paper; i.e., premiums are a direct function of losses. In another 1994 paper studying earthquake coverage, entitled, “The Effect of Costly Risk Bearing on Insurers’ Supply Decisions”, Anne Kleffner and Neil Doherty indicated that writing coverage for a catastrophic event increased the variance in insurers’ cash flows due to correlated losses and uncertainty regarding the actual loss distribution.  In other words, catastrophic coverage policies, such as those covering the risks of earthquakes or hurricanes, which carry a potentially high correlation for underwriters, can be safely written only by taking into account the entire underwriter’s portfolio and financial characteristics.  More specifically, the ability to underwrite a catastrophic event is directly related to the variance of a firm’s marginal costs.  The higher the marginal costs, the lower the amount of coverage that can be written.   In addition, because of differing abilities in raising external capital after a large loss, which affects profitability in the short term, the quantity of  insurance provided on the market is directly related to the structure of the underwriter in question. Marine premiums were beginning to tighten before the WTC attacks, based on deteriorating loss levels during the past two years.  After Sept 11, rate increases are averaging 25% for the 2002 policy year renewals.

1. Introduction
1.1 Protection & Indemnity Marine Insurance
1.2 Fixed-premium Marine Insurance
1.3 Literature Review
2. Section
2.1 Model
2.2 Data
2.3 Methodology
2.4 Testing
3. Discussion of Results
4. Conclusions

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