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David Elkin looks at the serious challenges facing the insurance industry, especially after recent flooding and freezing conditions.

The Irish insurance industry has faced up to two of the greatest disasters in its history over the last four months, in the shape of the November flooding and the big freeze in January. Both were natural disasters on an unprecedented scale in modern Ireland, and both could not have come at a worse time for an already fragile industry.

The floods in November of last year were a freak natural disaster but, according to UCD Professor Ray Kinsella, these events will become far more frequent and should be worked into the financial projections of the insurance industry in the future.

"All of the data shows that the frequency of natural disasters is increasing. There is no doubt at all about that and at some stage or other, that has to be passed on to the consumer. I would also say that probably much more extensive flooding will put pressure on premiums in certain parts of the country.

"I think that if you look at the meteorological data and look what is happening in flooding and climate change, I think it puts an awful lot of pressure on governments to ensure that in those parts of the country that are vulnerable to flooding, they take steps and do the necessary infrastructural work."

Mike Kemp, chief executive of the Irish Insurance Federation (IIF) agrees that more must be done in the area of flood defences and that the November crisis highlighted this problem.

 "The amount of resources that are put into flood defences are an issue because what was noticeable was that the areas that had work done effectively escaped the worst of the floods. Kilkenny used to be a bad spot and there was some considerable work done there and it worked. You're better off preventing the loss happening in the first place than worrying about it afterwards."

The November floods may have exposed a flaw in the planning process that was heavily exploited during the property boom. Kemp identifies this as an area that the IIF are looking into. "We have a suspicion that one of the major contributors to the size of this loss, is the fairly reckless development in flood-prone areas."

"Clearly, at the moment, it is not a huge issue in terms of the development that is going on now but it will be in the longer term, so we want to make sure that the opportunity is taken to get those kind of issues sorted in terms of the local development plans and the planning application process."

As the recession continues across all sectors of the economy, insurers in Ireland are not immune to the effect that a downturn can have on business. Revenues are down as consumers and businesses alike find ways of cutting back on fixed costs.

Kemp explains what areas of insurance are particularly affected by a shrinking economy.

"The economy and the industry are linked in terms of demand, and it has probably been even more obvious on the life and pensions side where there is more discretionary spending. Looking at non-life, you have to have motor insurance, and you effectively have to have household insurance if you have a mortgage loan, and businesses, as a matter of prudence, need the various commercial covers.

"With individual life and pensions, there is more likely to be discretionary spending and there has been quite a significant fall in the amount of spending that the life [insurance] companies have done. We are tied into the general economic outlook, and as and when there is a recovery, we would expect to see business volumes going up."

As businesses across Ireland shrink to cope with the pressure of the marketplace, insurance becomes a greater burden on a company, as Ray Kinsella explains, "Insurance costs are a fixed cost that are extremely important to the integrity of companies. Nevertheless, the pressures that are on Irish companies as a result of the recession are very significant and insurance is becoming proportionately greater as a cost.

"The cost of claims to insurance companies traditionally rises during this part of the cycle. Fraud is an issue. At the same time, their investment income has declined markedly."

The issue of fraud is, of course, one that has always plagued the industry. However, at times of economic downturn, the levels ramp up. Successful fraud, by its very nature, does not get noticed but the IIF is in a position to analyse where the main problems are.

"One of the issues in a recession is that you tend to see increases in the level of fraud, and that is something we have to be vigilant about, whether by exaggeration or fabrication of claims and levels of uninsured driving.

"There is a background low level of it all the time and it tends to increase when you hit hard times. Again, you would hope that as we come out of recession, you would see a drop off in that."

As with any industry dealing with such large amounts of capital, regulation is a big  issue and is driven mostly by the European Union. The system faces challenges though, as Kinsella explains,

"To develop a regulatory architecture for Europe, as part of a global system, is a very significant challenge. If you take the size of insurance and pensions, they are simply enormous and are big movers in the market. Their investments alone needed to fund their claims are enormous. They are under massive strain.

"To get a regulatory system that works on a global level and that can ensure small markets like Ireland aren't overwhelmed by global events, that is something that hasn't been tackled."

Mike Kemp has always identified the insurance regulator as lacking sufficient resources but says that this might be changing.

 "Certainly up until recently, they have been seriously under strength within the Regulator. There has been quite a lot of changes there in terms of management being appointed and there are senior positions still to be filled.

"We need a professional regulator that is properly resourced. I think they have been doing the best job they could within the resources and strains they have and they are recruiting quite a number of additional people at the moment to get up to full strength."

The next big EU regulation to come down the line to the Irish market is called Solvency II which is set to change the fundamental make-up of insurance regulation across the EU. The idea behind the directive is to create a much closer link between the solvency capital required and the actual risk profile of the company and in theory, make the industry more secure against unexpected events such as the ones in November and January. The combined effect of the directive will increase the amount of regulatory capital required considerably across the market.

The nature of investment by insurance companies and the effect the speculation can have on an economy are outlined by Kinsella.

"There were times, in the not-too distant past, where insurers were losing money on underwriting insurance. On the other hand, the investment gains they were making were allowing them to absorb those losses. That's not true anymore. Therefore, what is happening in the financial markets has an invisible, yet very real impact on premium incomes."

Kinsella goes on to cite AIG as a prime example of a major international insurance company that took its eye off its main market - that of insurance - and started speculating.

"The nature of insurance has changed in the sense that what is important to the consumer and what is important to the markets in which insurers operate, is stability.

"If a very large company, like AIG, gets it wrong then that impacts right across the board. It impacts not just on insurance but on the financial markets generally. That can have a disastrous effect in terms of the need for Government to intervene, at a huge cost to the consumer, to prop it up."

The industry as a whole is widely accepted to be cyclical with different sectors profitable at different periods, according to external factors. The current economic downturn, however, has thrown the usual three to five year cycle into turmoil, according to Kinsella.

 "The insurance industry has been coping with the cycle of three to five years very effectively for a very long time. It expects it and it is built into its model. The kind of cycle we are seeing now is not the traditional insurance cycle."

An interesting sub-sector of the industry in the current climate are the pensions and life insurance sectors. It not only partially represents the discretionary spending that has been one of the main areas of decline, but Ray Kinsella identifies a more fundamental issue at its core.

"People are, without doubt, living significantly longer. On the pension side, there is approaching a catastrophic gap in what we are prepared to put aside to save and what companies can afford to put aside from company schemes and what is needed to provide a reasonable level of pension cover when you retire. That is a time bomb, and the Government is not tackling it. It has crept up on us.

"We have moved by default from a defined benefit system to a defined contribution system. With the economy under huge strain, companies are finding it very difficult to fund their pension schemes. Many companies are closing their pension scheme to employees and finding it very difficult indeed to fund the schemes."

"There was a problem with double taxation with the pension, as essentially you buy two products - you're paying contributions in to build up the fund and then at retirement, you are buying an annuity with the fund.

So if this was maintained, people would have to pay 1% on their contributions and another 1% taken out of the lump sum when you buy the annuity. It is effectively double taxation which I don't think was intended in the first place."

For an industry that was shook to its core in November and, again just two months later in January, things could be a lot worse looking forward to 2010 and beyond.

There are areas that can be improved upon and fundamental changes in the pipeline. The industry will need to face these challenges, no matter what the unforeseen circumstances are.

After the floods and freeze

Calculating the cost to insurance

The floods and adverse weather conditions that consumed the country in November and January leading to serious personal loss on a widespread level, was also looked upon with great trepidation by the insurance industry.

The estimated cost of the floods to the industry is, at the moment, estimated to be in the region of €240-€250m, while the cost of the big freeze of January is still trying to be worked out. The two events could come to cost the industry in the region of €450-@500m.

Brian McNelis of the Irish Brokers Association identifies the two areas that the disasters fell under. "Between the two, it is certainly the biggest event in the history of insurance in Ireland. The floods, prior to Christmas, affected commercial businesses more. Then after Christmas, the snow and the burst pipes would have affected domestic houses, rented property and holiday homes."

The Irish Insurance Federation is trying as best they can to identify where the losses will come from. Chief executive Mike Kemp says:

"We had a couple of fairly significant weather incidents back in 2008 but the flood in November is going to cost something in the region of @240-250m.

"We're getting the numbers together now on the freeze, and while it probably won't have had the same effect on losses, it was widespread and prolonged. So it looks like we're going to be looking at something of the same order.

"You're looking at the two of the most serious weather-related insurance claim incidents ever. Rates have been going up a lot in property, particularly household, and the flood had more of an impact in commercial property than on the household but the freeze would be mostly household. So you're looking at a pretty serious financial position in both those classes of business, going forward."

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