Storm clouds ahead for insurers

This year is also more than usually confused. In principle, supply and demand drive insurance rates, so it should be easy. The more capital there is in the industry, the more insurance it can provide. With more money chasing a fixed amount of business, rates fall. The more economic activity there is, and the greater the incidence of or seeming likelihood of disaster as in a bad year predicted for hurricanes, the more demand increases and prices rise. It is rarely so clear-cut, however, which is one reason why the insurance cycle is notorious. It is an industry in a permanent state of flux.

But even by its own standards, this promises to be a particularly difficult year to read because so many normally aligned pressures are in conflict. Usually, for example, when stock markets and other asset classes fall, capital flows from them and into insurance. But the insurance industry is grappling with the credit crunch as much as everyone else. There was a period in the second half of last year when Japan and other Asian nations seemed ready to commit — and some small Lloyd's businesses were bought — but overall the amount has been limited and the appetite disappointing.

This is confusing the picture on rates. On the one hand, a shortage of capital and heavy losses on this year's wind storms should put prices up. On the other, the slowdown in world economic activity means there is less to insure. People and corporates also behave differently in bad times.

Companies become more risk averse, and want to cover more uncertainty with insurance. Individuals see insurance as one place to save money, and may, for example, cut the insurance on the car from fully comprehensive to third party, or increase the excess on household policies in return for lower rates and so forth.

There is also the uncertainty caused by the problems at AIG, which was the world's biggest insurer. Its people in London say they are holding on to a lot more of their business then their competitors had hoped — or claim — but, that said, the business is certainly more cautious. Theirs is an environment for a safe pair of hands, not market-grabbing heroics.

The claims picture is also cloudy. Economic downturns always mean a big jump in fraudulent claims as warehouses full of unsellable stock mysteriously burn down, and ships that cannot find cargoes sink. But there is a lag before these claims come through. Economic activity dropped sharply in 1990-91. The claims started to arrive in 1992-93. We are already in the middle of a sharp economic slowdown, so the industry expects fraud to surge before the end of this year. But of course it may already be happening and has just not been spotted.

Economic slowdowns, particularly those that hit the financial sector, also lead to a surge in litigation. We are already seeing a flow of claims against investment banks from customers who bought asset-backed securities in the mistaken belief they were buying quality — and claim they were mis-sold.

The banks generally have thus far shown a reluctance to let these matters be exposed in full public view, and out-of-court settlements are confidential, but there seems little doubt large sums of compensation have changed hands in several recent cases.

There will be many more such actions against intermediaries as a result of the alleged £50 billion Madoff fraud, and there will be as many again as private-equity deals start to collapse against the accountants, chartered surveyors lawyers and assorted advisers who played a part in valuing the assets at the top of the market.

There will also be genuine claims brought under trade protection policies of various forms to provide compensation for corporates when a counter-party goes out of business or fails to pay, and mortgage protection policies that compensate lenders when a householder is forced into default.

But again at this stage, there is no way of assessing how severe these claims may be, so the claims outlook for the insurance industry is unusually cloudy.

Of course, insurance underwriting is not the only place the money comes from. As important is the use the company makes of the insurance premiums it receives, and how it is invested pending the need to pay some of it out in claims. Here, too, the old certainties have been upset. The credit squeeze has cut returns that had almost been taken for granted.

Returns on high-quality government securities have plunged, and the risk attached to corporate bonds has soared. So the industry can no longer rely on the asset side of the balance sheet to save it from the mistakes it makes on the liabilities side — by getting its insurance pricing wrong.